Optimal Monetary Policy with Credit Augmented Liquidity Cycles

Ester Faia

No 414, 2008 Meeting Papers from Society for Economic Dynamics

Abstract: The optimal response of monetary policy to financial instability is a long standing question whose policy relevance is now emphasized by the increase in available liquidity and in firms’ financial exposure. Bernanke, Gertler and Gilchrist (1998) build a model in which credit frictions occur on the demand for capital investment and induce demand driven fluctuations which exacerbate shock transmission. In this context the policy maker does not face any trade-off as output stabilization is achieved through inflation targeting. I build a sticky price DSGE model in which the demand for working capital is affected both by a cost channel and an external finance premium. In this context the policy instrument affects the cost of collateralizable loans which in turn affects firms’ marginal cost and inflation dynamics (supply side driven fluctuations). The optimal monetary policy design is based upon both constrained and global Ramsey policies. Results show that: a) the optimal inflation level lies between zero and the one prescribed by the Friedman rule, b) the optimal dynamic path features deviations from price stability, c) the optimal rule features asset price targeting.

Date: 2008
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