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Optimal monetary policy with uncertainty about financial frictions

  • Moessner, Richhild
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    This paper studies optimal discretionary monetary policy in the presence of uncertainty about the degree of financial frictions. Changes in the degree of financial frictions are modelled as changes in parameters of a hybrid New-Keynesian model calibrated for the UK, following Bean, Larsen and Nikolov (2002). Uncertainty about the degree of financial frictions is modelled as Markov switching between regimes without and with strong financial frictions. Optimal monetary policy is determined for different scenarios of permanent and temporary regime shifts in financial frictions, as well as for variations in financial frictions over the business cycle. Optimal monetary policy is found to be state-dependent. In each state, optimal monetary policy depends on the transition probabilities between the different regimes. JEL Classification: E52, E58, E61, E44

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    Paper provided by European Central Bank in its series Working Paper Series with number 0639.

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    Date of creation: Jun 2006
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    Handle: RePEc:ecb:ecbwps:20060639
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    1. Fabrizio Zampolli & Andrew P. Blake, 2005. "Time Consistent Policy in Markov Switching Models," Computing in Economics and Finance 2005 134, Society for Computational Economics.
    2. Marianne Baxter & Robert G. King, 1999. "Measuring Business Cycles: Approximate Band-Pass Filters For Economic Time Series," The Review of Economics and Statistics, MIT Press, vol. 81(4), pages 575-593, November.
    3. Carlstrom, Charles T & Fuerst, Timothy S, 1997. "Agency Costs, Net Worth, and Business Fluctuations: A Computable General Equilibrium Analysis," American Economic Review, American Economic Association, vol. 87(5), pages 893-910, December.
    4. Backus, David & Driffill, John, 1986. "The Consistency of Optimal Policy in Stochastic Rational Expectations Models," CEPR Discussion Papers 124, C.E.P.R. Discussion Papers.
    5. Bernanke, B. & Gertler, M. & Gilchrist, S., 1998. "The Financial Accelerator in a Quantitative Business Cycle Framework," Working Papers 98-03, C.V. Starr Center for Applied Economics, New York University.
    6. Svensson, Lars E O & Williams, Noah, 2007. "Monetary Policy with Model Uncertainty: Distribution Forecast Targeting," CEPR Discussion Papers 6331, C.E.P.R. Discussion Papers.
    7. Michael Woodford, 1999. "Optimal monetary policy inertia," Proceedings, Federal Reserve Bank of San Francisco.
    8. Pearlman, Joseph G., 1992. "Reputational and nonreputational policies under partial information," Journal of Economic Dynamics and Control, Elsevier, vol. 16(2), pages 339-357, April.
    9. Richard Clarida & Jordi Gali & Mark Gertler, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," NBER Working Papers 7147, National Bureau of Economic Research, Inc.
    10. Bean, Charles & Larsen, Jens D. J. & Nikolov, Kalin, 2002. "Financial frictions and the monetary transmission mechanism: theory, evidence and policy implications," Working Paper Series 0113, European Central Bank.
    11. Söderlind, Paul, 1998. "Solution and Estimation of RE Macromodels with Optimal Policy," SSE/EFI Working Paper Series in Economics and Finance 256, Stockholm School of Economics.
    12. Söderström, Ulf, 1999. "Monetary policy with uncertain parameters," Working Paper Series 83, Sveriges Riksbank (Central Bank of Sweden).
    13. Narayana R. Kocherlakota, 2000. "Creating business cycles through credit constraints," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Sum, pages 2-10.
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