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Optimal monetary policy with uncertainty about financial frictions

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  • Moessner, Richhild
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    Abstract

    This paper studies optimal discretionary monetary policy in the presence of uncertainty about the degree of financial frictions. Changes in the degree of financial frictions are modelled as changes in parameters of a hybrid New-Keynesian model calibrated for the UK, following Bean, Larsen and Nikolov (2002). Uncertainty about the degree of financial frictions is modelled as Markov switching between regimes without and with strong financial frictions. Optimal monetary policy is determined for different scenarios of permanent and temporary regime shifts in financial frictions, as well as for variations in financial frictions over the business cycle. Optimal monetary policy is found to be state-dependent. In each state, optimal monetary policy depends on the transition probabilities between the different regimes. JEL Classification: E52, E58, E61, E44

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    Bibliographic Info

    Paper provided by European Central Bank in its series Working Paper Series with number 0639.

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    Date of creation: Jun 2006
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    Handle: RePEc:ecb:ecbwps:20060639

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    Keywords: financial frictions; monetary policy; uncertainty;

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    1. Richard Clarida & Jordi Galí & Mark Gertler, 1997. "The science of monetary policy: A new Keynesian perspective," Economics Working Papers 356, Department of Economics and Business, Universitat Pompeu Fabra, revised Apr 1999.
    2. Bernanke, Ben S. & Gertler, Mark & Gilchrist, Simon, 1999. "The financial accelerator in a quantitative business cycle framework," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 21, pages 1341-1393 Elsevier.
    3. Fabrizio Zampolli & Andrew P. Blake, 2005. "Time Consistent Policy in Markov Switching Models," Computing in Economics and Finance 2005 134, Society for Computational Economics.
    4. Carlstrom, Charles T & Fuerst, Timothy S, 1997. "Agency Costs, Net Worth, and Business Fluctuations: A Computable General Equilibrium Analysis," American Economic Review, American Economic Association, vol. 87(5), pages 893-910, December.
    5. Soderstrom, Ulf, 2002. " Monetary Policy with Uncertain Parameters," Scandinavian Journal of Economics, Wiley Blackwell, vol. 104(1), pages 125-45.
    6. Lars Svensson & Noah Williams, 2005. "Monetary Policy with Model Uncertainty: Distribution Forecast Targeting," NBER Working Papers 11733, National Bureau of Economic Research, Inc.
    7. Woodford, Michael, 1999. "Optimal Monetary Policy Inertia," Manchester School, University of Manchester, vol. 67(0), pages 1-35, Supplemen.
    8. Backus, David & Driffill, John, 1986. "The Consistency of Optimal Policy in Stochastic Rational Expectations Models," CEPR Discussion Papers 124, C.E.P.R. Discussion Papers.
    9. Söderlind, Paul, 1998. "Solution and Estimation of RE Macromodels with Optimal Policy," Working Paper Series in Economics and Finance 256, Stockholm School of Economics.
    10. Woodford, Michael, 1999. "Optimal monetary policy inertia," CFS Working Paper Series 1999/09, Center for Financial Studies (CFS).
    11. Bean, Charles & Larsen, Jens D. J. & Nikolov, Kalin, 2002. "Financial frictions and the monetary transmission mechanism: theory, evidence and policy implications," Working Paper Series 0113, European Central Bank.
    12. Pearlman, Joseph G., 1992. "Reputational and nonreputational policies under partial information," Journal of Economic Dynamics and Control, Elsevier, vol. 16(2), pages 339-357, April.
    13. Narayana R. Kocherlakota, 2000. "Creating business cycles through credit constraints," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Sum, pages 2-10.
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