Leverage, investment, and optimal monetary policy

Filippo Occhino and Andrea Pescatori ()

No 1238, Working Papers (Old Series) from Federal Reserve Bank of Cleveland

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: Business cycles; Monetary policy (search for similar items in EconPapers)
Date: 2012
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
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Journal Article: Leverage, investment, and optimal monetary policy (2014)
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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedcwp:1238

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DOI: 10.26509/frbc-wp-201238

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