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Credit Frictions and Optimal Monetary Policy

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  • Cúrdia, Vasco
  • Woodford, Michael

Abstract

The basic (representative-household) New Keynesian model of the monetary transmission mechanism is extended to allow for a spread between the interest rate available to savers and borrowers, and investigate the consequences of a variable credit spread for the effects of a variety of shocks, and for optimal policy responses to those shocks. A simple target criterion continues to provide a good approximation to optimal policy. Such a “flexible inflation target” can be implemented by a central-bank reaction function that is similar to a forward-looking Taylor rule, but adjusted for changes in current and expected future credit spreads.

Suggested Citation

  • Cúrdia, Vasco & Woodford, Michael, 2016. "Credit Frictions and Optimal Monetary Policy," Journal of Monetary Economics, Elsevier, vol. 84(C), pages 30-65.
  • Handle: RePEc:eee:moneco:v:84:y:2016:i:c:p:30-65
    DOI: 10.1016/j.jmoneco.2016.10.003
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    More about this item

    Keywords

    Credit spreads; Policy rules; Target criterion; Flexible inflation targeting; Quadratic loss function;

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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