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Credit Risks and Monetary Policy Trade-Offs

Author

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  • Kevin x.d. Huang

    () (Vanderbilt University)

  • J. scott Davis

    () (Federal Reserve Bank of Dallas)

Abstract

Financial frictions and financial shocks can affect the trade-off between inflation stabilization and output-gap stabilization faced by a central bank. Financial frictions lead to a greater response in output following any deviation of inflation from target and thus lead to an increase in the sacrifice ratio. As a result, optimal monetary policy in the face of credit frictions is to allow greater output gap instability in return for greater inflation stability. Such a shift in optimal monetary policy can be mimicked in a Taylor-type interest rate feedback rule that shifts weight to inflation and the lagged interest rate and away from output. However, the ability of the conventional Taylor rule to mimic optimal policy gets worse as credit market frictions and shocks intensify. By including a Â…financial variable like the lending spread in the monetary policy rule, the central bank can partially reverse this worsening output-inflation trade-off brought about by financial frictions and partially undo the effects of credit market frictions and shocks. Thus the central bank may want to include lending spreads in the policy rule even when Â…financial distortions are not explicitly part of the central bank'Â’s objective function.

Suggested Citation

  • Kevin x.d. Huang & J. scott Davis, 2013. "Credit Risks and Monetary Policy Trade-Offs," Vanderbilt University Department of Economics Working Papers 13-00004, Vanderbilt University Department of Economics.
  • Handle: RePEc:van:wpaper:vuecon-sub-13-00004
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    References listed on IDEAS

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    Cited by:

    1. Verona, Fabio & Martins, Manuel M.F. & Drumond, Inês, 2017. "Financial shocks, financial stability, and optimal Taylor rules," Journal of Macroeconomics, Elsevier, vol. 54(PB), pages 187-207.

    More about this item

    Keywords

    Credit friction; Credit shock; Credit spread; Monetary policy trade-offs; Taylor rule;

    JEL classification:

    • E0 - Macroeconomics and Monetary Economics - - General
    • G0 - Financial Economics - - General

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