Leverage, investment, and optimal monetary policy

Filippo Occhino and Andrea Pescatori ()

The B.E. Journal of Macroeconomics, 2014, vol. 14, issue 1, 511-531

Abstract: We study optimal monetary policy in an economy where firms’ debt overhangs lead to under-investment and under-production. The magnitude of this debt-induced distortion varies over the business cycle, rising significantly during recessions. When debt is contracted in nominal terms, this distortion gives rise to a balance sheet channel for monetary policy. In the presence of real and financial shocks, the monetary authority faces a trade-off between inflation and output gap stabilization. The optimal monetary policy rule prescribes that the anticipated component of inflation should be set equal to a target level, while the unanticipated component should rise in response to adverse shocks, smoothing the debt overhang distortion and the output gap.

Keywords: balance sheet channel of monetary policy; debt overhang; Fisher debt-deflation (search for similar items in EconPapers)
JEL-codes: E32 E52 (search for similar items in EconPapers)
Date: 2014
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Citations: View citations in EconPapers (12)

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Working Paper: Leverage, investment, and optimal monetary policy (2012)
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DOI: 10.1515/bejm-2013-0113

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