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Output Gap in Presence of Financial Frictions and Monetary Policy Trade-offs

Francesco Furlanetto (), Paolo Gelain () and Marzie Taheri Sanjani

No 14/128, IMF Working Papers from International Monetary Fund

Abstract: The recent global financial crisis illustrates that financial frictions are a significant source of volatility in the economy. This paper investigates monetary policy stabilization in an environment where financial frictions are a relevant source of macroeconomic fluctuation. We derive a measure of output gap that accounts for frictions in financial market. Furthermore we illustrate that, in the presence of financial frictions, a benevolent central bank faces a substantial trade-off between nominal and real stabilization; optimal monetary policy significantly reduces fluctuations in price and wage inflations but fails to alleviate the output gap volatility. This suggests a role for macroprudential policies.

Keywords: Business cycles; Economic growth; Econometric models; Potential output; Macroprudential Policy; Monetary policy; Financial Frictions, Optimal Monetary Policy, Output Gap, inflation, monetary economics, wage inflation, Model Construction and Estimation, Financial Markets and the Macroeconomy, Monetary Policy (Targets, Instruments, and Effects), Output Gap., (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
Date: 2014-07-18
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