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Output Gap in Presence of Financial Frictions and Monetary Policy Trade-Offs

45 Pages Posted: 14 Aug 2014  

Francesco Furlanetto

Norges Bank

Paolo Gelain

Norges Bank

Marzie Taheri Sanjani

International Monetary Fund (IMF)

Date Written: July 2014

Abstract

The recent global financial crisis illustrates that financial frictions are a significant source of volatility in the economy. This paper investigates monetary policy stabilization in an environment where financial frictions are a relevant source of macroeconomic fluctuation. We derive a measure of output gap that accounts for frictions in financial market. Furthermore we illustrate that, in the presence of financial frictions, a benevolent central bank faces a substantial trade-off between nominal and real stabilization; optimal monetary policy significantly reduces fluctuations in price and wage inflations but fails to alleviate the output gap volatility. This suggests a role for macroprudential policies.

Keywords: Economic growth, Business cycles, Monetary policy, Macroprudential Policy, Econometric models, Financial Frictions, Potential output, Optimal Monetary Policy, Output Gap., inflation, monetary economics, wage inflation, central bank, inflation target, price inflation, inflation stabilization, gdp deflator, monetary policy rule, nominal interest rate, monetary policy rules, stable prices, rational expectations, monetary fund, macroeconomic stability, long-term interest rates, nominal rate of return, inflation rate, inflation targeting, money markets, monetary authority, price stability, inflation dynamics, financial stability, monetary policy instrument, central bank monetary policy, real wage

JEL Classification: C51, E12, E24, E31, E32, E44, E52

Suggested Citation

Furlanetto, Francesco and Gelain, Paolo and Taheri Sanjani, Marzie, Output Gap in Presence of Financial Frictions and Monetary Policy Trade-Offs (July 2014). IMF Working Paper No. 14/128. Available at SSRN: https://ssrn.com/abstract=2480277

Francesco Furlanetto

Norges Bank ( email )

P.O. Box 1179
Oslo, N-0107
Norway

Paolo Gelain

Norges Bank ( email )

P.O. Box 1179
Oslo, N-0107
Norway

Marzie Taheri Sanjani

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

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