Optimal Monetary Policy Rules, Asset Prices and Credit Frictions

IGIER Working Paper No. 279

44 Pages Posted: 3 Feb 2005

See all articles by Ester Faia

Ester Faia

Goethe University Frankfurt; Kiel Institute for the World Economy; University of Angers - Centre d'Etudes Prospectives d'Economie Mathematique Appliquees a la Planification (CEPREMAP)

Tommaso Monacelli

Bocconi University - Department of Economics

Multiple version iconThere are 2 versions of this paper

Date Written: January 2005

Abstract

We study optimal monetary policy in two prototype economies with sticky prices and credit market frictions. In the first economy, credit frictions apply to the financing of the capital stock, generate acceleration in response to shocks and the "financial markup" (i.e., the premium on external funds) is countercyclical and negatively correlated with the asset price. In the second economy, credit frictions apply to the flow of investment, generate persistence, and the financial markup is procyclical and positively correlated with the asset price. We model monetary policy in terms of welfare-maximizing interest rate rules. The main finding of our analysis is that strict inflation stabilization is a robust optimal monetary policy prescription. The intuition is that, in both models, credit frictions work in the direction of dampening the cyclical behavior of inflation relative to its credit-frictionless level. Thus, neither economy, despite yielding different inflation and investment dynamics, generates a trade-off between price and financial markup stabilization. A corollary of this result is that reacting to asset prices does not bear any independent welfare role in the conduct of monetary policy.

Keywords: Optimal monetary policy rules, financial distortions, price stability, asset prices

Suggested Citation

Faia, Ester and Monacelli, Tommaso, Optimal Monetary Policy Rules, Asset Prices and Credit Frictions (January 2005). IGIER Working Paper No. 279. Available at SSRN: https://ssrn.com/abstract=659901 or http://dx.doi.org/10.2139/ssrn.659901

Ester Faia

Goethe University Frankfurt ( email )

Gr├╝neburgplatz 1
Frankfurt am Main, 60323
Germany

Kiel Institute for the World Economy

P.O. Box 4309
Kiel, D-24100
Germany

University of Angers - Centre d'Etudes Prospectives d'Economie Mathematique Appliquees a la Planification (CEPREMAP)

Ecole Normale Superieure
48 boulevard Jourdan
75014 Paris
France

Tommaso Monacelli (Contact Author)

Bocconi University - Department of Economics ( email )

Via Gobbi 5
Milan, 20136
Italy

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