Credit Market Distortions, Asset Prices And Monetary Policy

We study the conditions that ensure rational expectations equilibrium (REE) determinacy and expectational stability (E-stability) in a standard sticky-price model augmented with the cost channel. We allow for varying degrees of pass-through of the policy rate to bank-lending rates. Strong cost-side effects limit the size of the policy rate response to inflation that is consistent with determinacy, so that inflation-targeting policies may not be capable of ensuring REE uniqueness. In this case it is advisable to combine policy rate responses to inflation with an appropriate reaction to the output gap and/or firm profitability. The negative reaction of real activity and asset prices to inflationary shocks adds a negative force to inflation responses that counteracts the borrowing cost effect and prevents expectations of higher inflation from becoming self-fulfilling.