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Optimal Monetary Policy in a Financially Fragile Economy

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  • Demirel Ufuk D

    ()
    (University of Colorado at Boulder)

Abstract

This paper studies optimal monetary policy in an economy where firms rely heavily on external funds to finance operational costs. In the model, financial contracts are subject to agency problems and firms can possibly default on borrowed funds. Financial frictions have two separate effects on the model. First, they introduce an indirect cost channel to the monetary transmission mechanism. Second, they exacerbate the welfare costs of output gap fluctuations. The indirect cost channel implies that a given reduction in inflation can be achieved with a smaller output loss. This effect encourages the policy maker to emphasize inflation stabilization. At the same time, agency costs also make output gap fluctuations more costly in terms of economic welfare. This second effect encourages the policy maker to place more emphasis on output gap stabilization. Whether the optimal policy requires greater inflation stabilization or output gap stabilization depends on the balance of these two effects. Under a reasonable parametrization, the first effect dominates the second and the optimizing policy maker adopts a stricter anti-inflationary stance.

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Bibliographic Info

Article provided by De Gruyter in its journal The B.E. Journal of Macroeconomics.

Volume (Year): 9 (2009)
Issue (Month): 1 (May)
Pages: 1-37

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Handle: RePEc:bpj:bejmac:v:9:y:2009:i:1:n:15

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Cited by:
  1. Marcin Kolasa & Giovanni Lombardo, 2014. "Financial Frictions and Optimal Monetary Policy in an Open Economy," International Journal of Central Banking, International Journal of Central Banking, vol. 10(1), pages 43-94, March.
  2. Martina Cecioni & Giuseppe Ferrero & Alessandro Secchi, 2011. "Unconventional Monetary Policy in Theory and in Practice," Questioni di Economia e Finanza (Occasional Papers) 102, Bank of Italy, Economic Research and International Relations Area.
  3. Demirel, Ufuk Devrim, 2010. "Macroeconomic stabilization in developing economies: Are optimal policies procyclical?," European Economic Review, Elsevier, vol. 54(3), pages 409-428, April.
  4. Demirel, Ufuk Devrim, 2013. "Gains from commitment in monetary policy: Implications of the cost channel," Journal of Macroeconomics, Elsevier, vol. 38(PB), pages 218-226.

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