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Optimal Monetary Policy Rules, Asset Prices and Credit Frictions

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  • Ester Faia
  • Tommaso Monacelli

Abstract

We study optimal monetary policy in two prototype economies with sticky prices and credit market frictions. In the first economy, credit frictions apply to the financing of the capital stock, generate acceleration in response to shocks and the ”financial markup” (i.e., the premium on external funds) is countercyclical and negatively correlated with the asset price. In the second economy, credit frictions apply to the flow of investment, generate persistence, and the financial markup is procyclical and positively correlated with the asset price. We model monetary policy in terms of welfare-maximizing interest rate rules. The main finding of our analysis is that strict inflation stabilization is a robust optimal monetary policy prescription. The intuition is that, in both models, credit frictions work in the direction of dampening the cyclical behavior of inflation relative to its credit-frictionless level. Thus neither economy, despite yielding different inflation and investment dynamics, generates a trade-off between price and financial markup stabilization. A corollary of this result is that reacting to asset prices does not bear any independent welfare role in the conduct of monetary policy.

Suggested Citation

  • 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.
  • Handle: RePEc:igi:igierp:279
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    Cited by:

    1. Faia, Ester & Lechthaler, Wolfgang & Merkl, Christian, 2009. "Labor Turnover Costs, Workers' Heterogeneity, and Optimal Monetary Policy," IZA Discussion Papers 4322, Institute for the Study of Labor (IZA).
    2. Fiorella De Fiore & Pedro Teles & Oreste Tristani, 2011. "Monetary Policy and the Financing of Firms," American Economic Journal: Macroeconomics, American Economic Association, vol. 3(4), pages 112-142, October.
    3. De Graeve, Ferre, 2008. "The external finance premium and the macroeconomy: US post-WWII evidence," Journal of Economic Dynamics and Control, Elsevier, vol. 32(11), pages 3415-3440, November.
    4. Mara Pirovano, 2013. "Household and firm leverage, capital flows and monetary policy in a small open economy," Working Paper Research 246, National Bank of Belgium.
    5. Marta Areosa & Waldyr Areosa, 2012. "Asset Prices and Monetary Policy – A sticky-dispersed information model," Working Papers Series 285, Central Bank of Brazil, Research Department.
    6. Eleni Iliopulos & Thepthida Sopraseuth, 2012. "L'intermédiation financière dans l'analyse macroéconomique : le défi de la crise," Économie et Statistique, Programme National Persée, vol. 451(1), pages 91-130.
    7. Yasuo Hirose, 2008. "Equilibrium Indeterminacy and Asset Price Fluctuation in Japan: A Bayesian Investigation," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 40(5), pages 967-999, August.
    8. Nolan, Charles & Thoenissen, Christoph, 2009. "Financial shocks and the US business cycle," Journal of Monetary Economics, Elsevier, vol. 56(4), pages 596-604, May.
    9. Fendoğlu, Salih, 2014. "Optimal monetary policy rules, financial amplification, and uncertain business cycles," Journal of Economic Dynamics and Control, Elsevier, vol. 46(C), pages 271-305.
    10. Baxa, Jaromír & Horváth, Roman & Vašíček, Bořek, 2013. "Time-varying monetary-policy rules and financial stress: Does financial instability matter for monetary policy?," Journal of Financial Stability, Elsevier, vol. 9(1), pages 117-138.
    11. Nisticò, Salvatore, 2012. "Monetary policy and stock-price dynamics in a DSGE framework," Journal of Macroeconomics, Elsevier, vol. 34(1), pages 126-146.
    12. David Aikman & Matthias Paustian, 2006. "Bank capital, asset prices and monetary policy," Bank of England working papers 305, Bank of England.
    13. Merola, Rossana, 2010. "Optimal monetary policy in a small open economy with financial frictions," Discussion Paper Series 1: Economic Studies 2010,01, Deutsche Bundesbank.
    14. Nan-Kuang Chen & Hung-Jen Wang, 2007. "The Procyclical Leverage Effect Of Collateral Value On Bank Loans-Evidence From The Transaction Data Of Taiwan," Economic Inquiry, Western Economic Association International, vol. 45(2), pages 395-406, April.
    15. repec:hal:psewpa:halshs-00744047 is not listed on IDEAS
    16. Agnès Bénassy-Quéré & Véronique Salins, 2010. "A Case for Intermediate Exchange-Rate Regimes," Working Papers 2010-14, CEPII research center.

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    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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