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Optimal Monetary Policy Rules, Financial Amplification, and Uncertain Business Cycles

  • Salih Fendoglu

This paper studies whether financial variables per se should matter for monetary policy. Earlier consensus view - using financial amplification models with disturbances that have no direct effect on credit market conditions- suggests that financial variables should not be assigned an independent role in policy making. Introducing uncertainty, time- variation in cross-sectional dispersion of firms’ productive performance, alters this policy prescription. The results show that (i) optimal policy is to dampen the strength of financial amplification by responding to uncertainty (at the expense of creating a mild degree of fluctuations in inflation). Moreover, a higher uncertainty makes the planner more willing to relax the financial constraints. (ii) Credit spreads are a good proxy for uncertainty, and hence, within the class of simple monetary policy rules I consider, a non-negligible response to credit spreads -together with a strong anti-inflationary stance- achieves the highest aggregate welfare possible.

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Paper provided by Research and Monetary Policy Department, Central Bank of the Republic of Turkey in its series Working Papers with number 1126.

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Date of creation: 2011
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Handle: RePEc:tcb:wpaper:1126
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