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Can Financial Frictions Help Explain the Performance of the US Fed?

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  • Beatriz de-Blas-Pérez
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    This paper investigates whether the presence of financial frictions can help explain the differences in the variability of output and inflation between the Pre- and the Post-Volcker periods. I use a limited participation model with credit market imperfections, in which financial frictions may alter the stabilization effects of monetary policy, as shown in a previous paper of mine. In this setup, I study the interest rate rule followed by the Federal Reserve Bank in the last 40 years considering the presence of credit market imperfections and allowing for a breakpoint in the monetary policy rule, the degree of financial frictions and shock processes. An interest rate rule is estimated for each of the two identified sub-samples. In the absence of financial frictions, the results confirm the widely recognized change in the conduct of monetary policy by reporting substantially different interest rate rules before and after 1981:2, but fail to assign more weight to inflation stabilization in the second sub-sample. Interestingly, with positive monitoring costs the two calibrated rules are much less different, that is, a far smaller change in policy suffices for stabilization when imperfect credit markets are considered. This may suggest a key role for credit market imperfections in the stabilization effects of monetary policy. When the rule, shocks and monitoring costs are allowed to adjust between sub-samples, the calibration reports interest rate rules that assign more weight to inflation and less to output stabilization after 1981:2. Money demand processes vary between sub-samples, whereas technology innovations remain relatively stable across time, which is consistent with standard literature

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    Paper provided by Econometric Society in its series Econometric Society 2004 North American Winter Meetings with number 543.

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    Date of creation: 11 Aug 2004
    Handle: RePEc:ecm:nawm04:543
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