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Credit and the natural rate of interest

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  • De Fiore, Fiorella
  • Tristani, Oreste

Abstract

We analyze the properties of the natural rate of interest in an economy where nominal debt contracts generate a spread between loan rates and the policy interest rate. In our model, monetary policy has real effects in the flexible-price equilibrium, because it affects the credit spread. Relying on a definition suitable for this environment, we demonstrate that: (i) the natural rate is independent of monetary policy and (ii) it delivers price stability, if used as the intercept of a monetary policy rule. The second result holds exactly if real balances are remunerated at a constant spread below policy interest rates, approximately otherwise. We also highlight, however, that the natural rate is not robust to model un-certainty. The natural rate reacts differently to aggregate shocks - not only quantitatively but also qualitatively - depending on the underlying model assumptions (e.g. whether or not financial markets are frictionless). JEL Classification: E40, E50, G10

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Bibliographic Info

Paper provided by European Central Bank in its series Working Paper Series with number 0889.

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Date of creation: Apr 2008
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Handle: RePEc:ecb:ecbwps:20080889

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Keywords: credit frictions; monetary policy; Natural rate of interest;

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  1. Queijo, Virginia, 2005. "How Important are Financial Frictions in the U.S. and Euro Area?," Seminar Papers 738, Stockholm University, Institute for International Economic Studies.
  2. Charles T. Carlstrom & Timothy S. Fuerst, 1996. "Agency costs, net worth, and business fluctuations: a computable general equilibrium analysis," Working Paper 9602, Federal Reserve Bank of Cleveland.
  3. (Kim | Lopez-Salido | Swanson) & Andrew Levin, 2004. "The magnitude and Cyclical Behavior of Financial Market Frictions," Computing in Economics and Finance 2004 224, Society for Computational Economics.
  4. Lawrence J. Christiano & Martin Eichenbaum & Charles L. Evans, 2005. "Nominal Rigidities and the Dynamic Effects of a Shock to Monetary Policy," Journal of Political Economy, University of Chicago Press, vol. 113(1), pages 1-45, February.
  5. Marvin J. Barth III & Valerie A. Ramey, 2000. "The Cost Channel of Monetary Transmission," NBER Working Papers 7675, National Bureau of Economic Research, Inc.
  6. Ravenna, Federico & Walsh, Carl E., 2006. "Optimal monetary policy with the cost channel," Journal of Monetary Economics, Elsevier, vol. 53(2), pages 199-216, March.
  7. Gale, Douglas & Hellwig, Martin, 1985. "Incentive-Compatible Debt Contracts: The One-Period Problem," Review of Economic Studies, Wiley Blackwell, vol. 52(4), pages 647-63, October.
  8. Timothy S. Fuerst & Charles T. Carlstrom, 1998. "Agency costs and business cycles," Economic Theory, Springer, vol. 12(3), pages 583-597.
  9. Ben Bernanke & Mark Gertler & Simon Gilchrist, 1998. "The Financial Accelerator in a Quantitative Business Cycle Framework," NBER Working Papers 6455, National Bureau of Economic Research, Inc.
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Cited by:
  1. Claudio Borio & Piti Disyatat, 2011. "Global imbalances and the financial crisis: Link or no link?," BIS Working Papers 346, Bank for International Settlements.
  2. Woon Gyu Choi & David Cook, 2010. "Fire Sales and the Financial Accelerator," IMF Working Papers 10/141, International Monetary Fund.
  3. Kobayashi, Teruyoshi, 2009. "Firm entry and monetary policy transmission under credit rationing," MPRA Paper 17553, University Library of Munich, Germany.
  4. Fiorella De Fiore & Oreste Tristani, 2013. "Optimal Monetary Policy in a Model of the Credit Channel," Economic Journal, Royal Economic Society, vol. 123(571), pages 906-931, 09.
  5. Otmar Issing, 2009. "In search of monetary stability: the evolution of monetary policy," BIS Working Papers 273, Bank for International Settlements.

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