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Optimal Monetary Policy with Credit Augmented Liquidity Cycles

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  • Ester Faia

    (University of Rome at Tor Vergata)

Abstract

The optimal response of monetary policy to financial instability is a long standing question whose policy relevance is now emphasized by the increase in available liquidity and in firms’ financial exposure. Bernanke, Gertler and Gilchrist (1998) build a model in which credit frictions occur on the demand for capital investment and induce demand driven fluctuations which exacerbate shock transmission. In this context the policy maker does not face any trade-off as output stabilization is achieved through inflation targeting. I build a sticky price DSGE model in which the demand for working capital is affected both by a cost channel and an external finance premium. In this context the policy instrument affects the cost of collateralizable loans which in turn affects firms’ marginal cost and inflation dynamics (supply side driven fluctuations). The optimal monetary policy design is based upon both constrained and global Ramsey policies. Results show that: a) the optimal inflation level lies between zero and the one prescribed by the Friedman rule, b) the optimal dynamic path features deviations from price stability, c) the optimal rule features asset price targeting.

Suggested Citation

  • Ester Faia, 2008. "Optimal Monetary Policy with Credit Augmented Liquidity Cycles," 2008 Meeting Papers 414, Society for Economic Dynamics.
  • Handle: RePEc:red:sed008:414
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    File URL: https://economicdynamics.org/meetpapers/2008/paper_414.pdf
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    References listed on IDEAS

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    1. Bernardino Adão & Isabel Correia & Pedro Teles, 2003. "Gaps and Triangles," Review of Economic Studies, Oxford University Press, vol. 70(4), pages 699-713.
    2. Schmitt-Grohé, Stephanie & Uribe, Martín, 2004. "Optimal Operational Monetary Policy in the Christiano-Eichenbaum-Evans Model of the US Business Cycle," CEPR Discussion Papers 4654, C.E.P.R. Discussion Papers.
    3. Carlstrom, Charles T & Fuerst, Timothy S, 1997. "Agency Costs, Net Worth, and Business Fluctuations: A Computable General Equilibrium Analysis," American Economic Review, American Economic Association, vol. 87(5), pages 893-910, December.
    4. Chari, V V & Christiano, Lawrence J & Kehoe, Patrick J, 1991. "Optimal Fiscal and Monetary Policy: Some Recent Results," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 23(3), pages 519-539, August.
    5. Faia, Ester & Monacelli, Tommaso, 2007. "Optimal interest rate rules, asset prices, and credit frictions," Journal of Economic Dynamics and Control, Elsevier, vol. 31(10), pages 3228-3254, October.
    6. Lucas, Robert Jr. & Stokey, Nancy L., 1983. "Optimal fiscal and monetary policy in an economy without capital," Journal of Monetary Economics, Elsevier, vol. 12(1), pages 55-93.
    7. Schmitt-Grohe, Stephanie & Uribe, Martin, 2004. "Solving dynamic general equilibrium models using a second-order approximation to the policy function," Journal of Economic Dynamics and Control, Elsevier, vol. 28(4), pages 755-775, January.
    8. Kydland, Finn E. & Prescott, Edward C., 1980. "Dynamic optimal taxation, rational expectations and optimal control," Journal of Economic Dynamics and Control, Elsevier, vol. 2(1), pages 79-91, May.
    9. Bernardino Adao, 2000. "Gaps and Triangles," Econometric Society World Congress 2000 Contributed Papers 1904, Econometric Society.
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    Cited by:

    1. repec:taf:intecj:v:31:y:2017:i:1:p:1-35 is not listed on IDEAS
    2. Claudio Cesaroni, 2017. "Optimal Long-Run Inflation and the Informal Economy," Bank of Lithuania Working Paper Series 46, Bank of Lithuania.

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