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Welfare Effects of Monetary Policy Rules in a Model with Nominal Rigidities and Credit Market Frictions

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  • Matthias Paustian
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    Abstract

    This paper evaluates monetary policy rules in a business cycle model with staggered prices and wage setting a la Calvo and asymmetric information in the credit market. Rules are compared in a utility based welfare metric, the effects of the model’s nonlinear dynamics are captured by a quadratic approximation to the policy function. The firms net worth crucially affects the terms of obtaining outside finance. Financial frictions dampen the economy’s response to shocks and make them more persistent. For the baseline calibration, the welfare costs of price stickiness are found to be less than 0.04 per cent of steady state consumption. However, wage stickiness can induce welfare costs of up to 0.85 per cent of steady state consumption. An interest rate rule that places high weight on stabilizing wage inflation can eliminate most of these costs. These findings are by and large independent of the existence of other real distortions in the model, namely credit frictions

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    Bibliographic Info

    Paper provided by Econometric Society in its series Econometric Society 2004 Far Eastern Meetings with number 597.

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    Date of creation: 11 Aug 2004
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    Handle: RePEc:ecm:feam04:597

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    Keywords: Monetary policy rules; nominal rigidities; welfare evaluation; quadratic approximation; agency costs; credit frictions.;

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    1. Mankiw, N. Gregory & Reis, Ricardo, 2003. "What Measure of Inflation Should a Central Bank Target?," Scholarly Articles 3415322, Harvard University Department of Economics.
    2. Julio J. Rotemberg & Michael Woodford, 1998. "Interest-Rate Rules in an Estimated Sticky Price Model," NBER Working Papers 6618, National Bureau of Economic Research, Inc.
    3. Lawrence J. Christiano & Martin Eichenbaum & Charles Evans, 2001. "Nominal rigidities and the dynamic effects of a shock to monetary policy," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
    4. Charles T. Carlstrom & Timothy S. Fuerst, 2000. "Monetary shocks, agency costs, and business cycles," Working Paper 0011, Federal Reserve Bank of Cleveland.
    5. Jinill Kim & Sunghyun Henry Kim, 1999. "Spurious Welfare Reversals in International Business Cycle Models," Virginia Economics Online Papers 319, University of Virginia, Department of Economics.
    6. Basu, S.: Fernald, J.G., 1993. "Constant Returns and Small Markups in U.S. Manufacturing," Papers 93-19, Michigan - Center for Research on Economic & Social Theory.
    7. Bils, Mark & Chang, Yongsung, 2003. "Welfare costs of sticky wages when effort can respond," Journal of Monetary Economics, Elsevier, vol. 50(2), pages 311-330, March.
    8. Paul Harrison & Oren Sussman & Joseph Zeira, 1999. "Finance and growth: theory and new evidence," Finance and Economics Discussion Series 1999-35, Board of Governors of the Federal Reserve System (U.S.).
    9. 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.
    10. Manuel S. Santos, 2000. "Accuracy of Numerical Solutions using the Euler Equation Residuals," Econometrica, Econometric Society, vol. 68(6), pages 1377-1402, November.
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