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Leverage, investment, and optimal monetary policy

  • Filippo Occhino
  • Andrea Pescatori

We study optimal monetary policy in an economy where firms’ debt overhangs lead to under-investment and under-production. The magnitude of this debt-induced distortion varies over the business cycle, rising significantly during recessions. When debt is contracted in nominal terms, this distortion gives rise to a balance sheet channel for monetary policy. In the presence of real and financial shocks, the monetary authority faces a trade-off between inflation and output gap stabilization. The optimal monetary policy rule prescribes that the anticipated component of inflation should be set equal to a target level, while the unanticipated component should rise in response to adverse shocks, smoothing the debt overhang distortion and the output gap.

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Paper provided by Federal Reserve Bank of Cleveland in its series Working Paper with number 1238.

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Date of creation: 2012
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Handle: RePEc:fip:fedcwp:1238
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