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Monetary Policy and the Financing of Firms

  • De Fiore, Fiorella
  • Teles, Pedro
  • Tristani, Oreste

How should monetary policy respond to changes in financial conditions? In this paper we consider a simple model where firms are subject to idiosyncratic shocks which may force them to default on their debt. Firms’ assets and liabilities are denominated in nominal terms and predetermined when shocks occur. Monetary policy can therefore affect the real value of funds used to finance production. Furthermore, policy affects the loan and deposit rates. In our model, allowing for short-term inflation volatility in response to exogenous shocks can be optimal; the optimal response to adverse financial shocks is to lower interest rates, if not at the zero bound, and to engineer a short period of controlled inflation; the Taylor rule may implement allocations that have opposite cyclical properties to the optimal ones. JEL Classification: E20, E44, E52

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Paper provided by European Central Bank in its series Working Paper Series with number 1123.

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Date of creation: Dec 2009
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Handle: RePEc:ecb:ecbwps:20091123
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  1. Lawrence J. Christiano & Roberto Motto & Massimo Rostagno, 2003. "The Great Depression and the Friedman-Schwartz hypothesis," Proceedings, Federal Reserve Bank of Cleveland, pages 1119-1215.
  2. Ester Faia & Tommaso Monacelli, 2005. "Optimal Monetary Policy Rules, Asset Prices and Credit Frictions," Working Papers 279, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University.
  3. De Fiore, Fiorella & Tristani, Oreste, 2009. "Optimal monetary policy in a model of the credit channel," Working Paper Series 1043, European Central Bank.
  4. Bernanke, Ben S. & Gertler, Mark & Gilchrist, Simon, 1999. "The financial accelerator in a quantitative business cycle framework," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 21, pages 1341-1393 Elsevier.
  5. Charles T. Carlstrom & Timothy S. Fuerst, 1996. "Agency costs, net worth, and business fluctuations: a computable general equilibrium analysis," Working Paper 9602, Federal Reserve Bank of Cleveland.
  6. Vasco Cúrdia & Michael Woodford, 2008. "Credit frictions and optimal monetary policy," Working Paper Research 146, National Bank of Belgium.
  7. Ravenna, Federico & Walsh, Carl E., 2006. "Optimal monetary policy with the cost channel," Journal of Monetary Economics, Elsevier, vol. 53(2), pages 199-216, March.
  8. Charles T. Carlstrom & Timothy S. Fuerst, 2000. "Monetary shocks, agency costs, and business cycles," Working Paper 0011, Federal Reserve Bank of Cleveland.
  9. Charles T. Carlstrom & Timothy S. Fuerst & Matthias Paustian, 2010. "Optimal Monetary Policy in a Model with Agency Costs," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 42(s1), pages 37-70, 09.
  10. Andrew T. Levin & Fabio M. Natalucci, 2005. "The Magnitude and Cyclical Behavior of Financial Market Frictions," 2005 Meeting Papers 443, Society for Economic Dynamics.
  11. Timothy S. Fuerst & Charles T. Carlstrom, 1998. "Agency costs and business cycles," Economic Theory, Springer, vol. 12(3), pages 583-597.
  12. Gilchrist, Simon & Leahy, John V., 2002. "Monetary policy and asset prices," Journal of Monetary Economics, Elsevier, vol. 49(1), pages 75-97, January.
  13. Ester Faia, 2008. "Optimal Monetary Policy with Credit Augmented Liquidity Cycles," 2008 Meeting Papers 414, Society for Economic Dynamics.
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