How should monetary policy respond to changes in financial conditions? In this paper we consider a simple model where firms are subject to idyosincratic shocks which may force them to default on their debt. Firms' assets and liabilities are denominated in nominal terms and predetermined when shocks occur. Monetary policy can therefore affect the real value of funds used to finance production. Furthermore, policy affects the loan and deposit rates. We find that maintaining price stability at all times is not optimal; that the optimal response to adverse financial shocks is to lower interest rates, if not at the zero bound, and engineer a short period of inflation; that the Taylor rule may implement allocations that have opposite cyclical properties to the optimal ones.
Downloads: (external link) http://www.cepr.org/pubs/dps/DP7419.asp (application/pdf)
CEPR Discussion Papers are free to download for our researchers, subscribers and members. If you fall into one of these categories but have trouble downloading our papers, please contact us at email@example.com