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Optimal Monetary Policy with Countercyclical Credit Spreads

Marco Airaudo and María Pía Olivero

Journal of Money, Credit and Banking, 2019, vol. 51, issue 4, 787-829

Abstract: We study optimal monetary policy in a New‐Keynesian Dynamic Stochastic General Equilibrium (DSGE) model with a credit channel and relationship lending in banking. We show that borrowers' bank‐specific (deep) habits give rise to countercyclical credit spreads, which, in turn, make optimal monetary policy depart substantially from price stability, under both discretion and commitment. Our analysis shows that the welfare costs of setting monetary policy under discretion (with respect to the optimal Ramsey plan) and of using simpler suboptimal policy rules are strictly increasing in the magnitude of deep habits in credit markets and market power in banking.

Date: 2019
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Handle: RePEc:wly:jmoncb:v:51:y:2019:i:4:p:787-829