Business Cycles and Financial Frictions under Money Growth Rule

In the last few years, macroeconomic modeling has emphasized the role of credit market frictions in magnifying and transmitting nominal and real disturbances and their implication for macro-prudential policy design. In this paper, I construct a modest New Keynesian general equilibrium model with active banking sector. In this set-up, the financial sector interacts with the real side of the economy via firm balance sheet and bank capital conditions and through their impact on investment and production decisions. I rely on the financial accelerator mechanism due to Bernanke et al. (1999) and combine it with a bank capital channel as demonstrated by Aguiar and Drumond (2007). The resulting model is calibrated from the perspective of a low-income economy reflecting the existence of relatively high investment adjustment cost, strong fiscal dominance, and underdeveloped financial and capital markets. The main objective of this exercise is to see whether the financial accelerator mechanism documented under interest-rate-rule based simulations could be replicated under a situation where the central bank uses money growth rule in stabilizing the national economy. The findings are broadly consistent with previous studies that demonstrated stronger role for credit market imperfections in amplifying and propagating monetary policy shocks.