Debt Constraints and Monetary Policy

Abstract

In the present paper we show how simple monetary policies can mitigate real effects of credit frictions. We consider stationary overlapping generations economies in which consumers are not equally efficient in producing capital and cannot commit to repay loans. The presence of money in itself does not mitigate the real effects of credit frictions. Equilibrium allocations are generally not Pareto optimal unless the returns on money and capital production are identical for more productive consumers. However, printing money and distributing it to young consumers increase their incomes allowing young more productive consumers to produce more capital. Consequently money printing increases output.

Keywords: financial frictions, monetary policy, overlapping generations economies

JEL Classification: D5, E4, E5