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Leverage, investment, and optimal monetary policy

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  • Filippo Occhino
  • Andrea Pescatori

Abstract

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.

Suggested Citation

  • Filippo Occhino & Andrea Pescatori, 2012. "Leverage, investment, and optimal monetary policy," Working Paper 1238, Federal Reserve Bank of Cleveland.
  • Handle: RePEc:fip:fedcwp:1238
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    References listed on IDEAS

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    Cited by:

    1. Jakucionyte, Egle & van Wijnbergen, Sweder, 2017. "Debt Overhang and the Macroeconomics of Carry Trade," CEPR Discussion Papers 11788, C.E.P.R. Discussion Papers.
    2. Urban Jermann & Lukas Schmid & Joao Gomes, 2014. "Sticky Leverage," 2014 Meeting Papers 40, Society for Economic Dynamics.
    3. Occhino, Filippo & Pescatori, Andrea, 2015. "Debt overhang in a business cycle model," European Economic Review, Elsevier, vol. 73(C), pages 58-84.
    4. repec:eee:eecrev:v:100:y:2017:i:c:p:337-363 is not listed on IDEAS
    5. James Bullard & Jacek Suda & Aarti Singh & Costas Azariadis, 2014. "Debt Overhang and Monetary Policy," 2014 Meeting Papers 948, Society for Economic Dynamics.
    6. Occhino, Filippo, 2014. "Debt-Overhang Banking Crises," Working Paper 1425, Federal Reserve Bank of Cleveland.
    7. Occhino, Filippo, 2015. "The 2012 Eurozone Crisis and the ECB’s OMT Program: A Debt-Overhang Banking and Sovereign Crisis Interpretation The 2012 Eurozone Crisis and the ECB’s OMT Program: A Debt-Overhang Banking and Sovereig," Working Paper 1509, Federal Reserve Bank of Cleveland.
    8. repec:eee:finsta:v:30:y:2017:i:c:p:192-208 is not listed on IDEAS

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    Keywords

    Business cycles ; Monetary policy;

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