WORKING PAPER SERIES NO 1043 / APRIL 2009 OPTIMAL MONETARY POLICY IN A MODEL OF THE CREDIT CHANNEL by Fiorella De F iore and Oreste Tristani WORKING PAPER SERIES NO 1043 / APRIL 2009 OPTIMAL MONETARY POLICY IN A MODEL OF THE CREDIT CHANNEL 1 by Fiorella De Fiore and Oreste Tristani 2 In 2009 all ECB publications This paper can be downloaded without charge from feature a motif http://www.ecb.europa.eu or from the Social Science Research Network taken from the €200 banknote. electronic library at http://ssrn.com/abstract_id=1383502. 1 We wish to thank Michael Woodford for many interesting discussions and Krzysztof Zalewski for excellent research assistance. We also thank for useful comments and suggestions Kosuke Aoki, Ester Faia, Giovanni Lombardo, Pedro Teles, Christian Upper, Tony Yates and seminar participants at the EEA 2008 meetings, CEF 2008, the Norges Bank Workshop on “Optimal Monetary Policy”, the BIS-CEPR-ESI 12th Annual Conference on “The Evolving Financial system and the Transmission Mechanism of Monetary Policy”, the Swiss National Bank Research Conference 2008 on “Alternative Models for Monetary Policy Analysis” and seminars at the Bank of England, the University of Aarhus and the Università Cattolica in Milan. 2 European Central Bank, DG Research, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany; e-mail: [email protected], [email protected] © European Central Bank, 2009 Address Kaiserstrasse 29 60311 Frankfurt am Main, Germany Postal address Postfach 16 03 19 60066 Frankfurt am Main, Germany Telephone +49 69 1344 0 Website http://www.ecb.europa.eu Fax +49 69 1344 6000 All rights reserved. Any reproduction, publication and reprint in the form of a different publication, whether printed or produced electronically, in whole or in part, is permitted only with the explicit written authorisation of the ECB or the author(s). The views expressed in this paper do not necessarily refl ect those of the European Central Bank. The statement of purpose for the ECB Working Paper Series is available from the ECB website, http://www.ecb.europa. eu/pub/scientific/wps/date/html/index. en.html ISSN 1725-2806 (online) CONTENTS Abstract 4 Non-technical summary 5 1 Introduction 6 2 The environment 9 2.1 Households 10 2.2 Wholesale fi rms 12 2.3 Retail fi rms 16 2.4 Monetary policy 18 2.5 Market clearing 19 3 The linearized equilibrium conditions 20 3.1 Impulse responses 23 4 Second order welfare approximation 26 5 Optimal policy 30 5.1 Discretion 30 5.2 Optimal monetary policy under commitment 30 6 Conclusion 33 Appendices 34 References 42 Figures 44 European Central Bank Working Paper Series 48 ECB Working Paper Series No 1043 April 2009 3 Abstract We consider a simple extension of the basic new-Keynesian setup in which we relax the assumption of frictionless financial markets. In our economy, asymmetric information and default risk lead banks to optimally charge a lending rate above the risk-free rate. Our contribution is threefold. First, we derive analytically the loglinearised equations which characterise aggregate dynamics in our model and show that they nest those of the new- Keynesian model. A key difference is that marginal costs increase not only with the output gap, but also with the credit spread and the nominal interest rate. Second, we find that financial market imperfections imply that exogenous disturbances, including technology shocks, generate a trade-off between output and inflation stabilisation. Third, we show that, in our model, an aggressive easing of policy is optimal in response to adverse financial market shocks. Keywords: optimal monetary policy, financial markets, asymmetric information JEL Classification: E52, E44 ECB Working Paper Series No 1043 4 April 2009 Non-technical summary We analyse whether and how financial market conditions ought to have a bearing on monetary policy decisions. More specifically, we ask the following questions: Should financial market variables matter per se for monetary policy, or should they only be taken into account to the extent that they affect output and inflation? Can financial shocks that increase credit spreads generate a large enough economic reaction to justify aggressive interest rate cuts? We present a simple extension of the basic new-Keynesian setup in which we relax the assumption of frictionless financial markets. In our model, asymmetric information and default risk lead banks to charge a lending rate above the risk-free rate. Moreover, financial contracts are denominated in nominal terms, so that monetary policy affects firms’ financing costs. Our contribution is threefold. First, we show that the log-linearised equations which characterise the aggregate dynamics in our model nest those of the new-Keynesian model. A key difference is that marginal costs increase not only with the output gap, but also with the credit spread and the nominal interest rate. Moreover, financial market imperfections imply that exogenous disturbances, including technology shocks, generate a trade-off between output and inflation stabilisation. Second, we derive a second-order approximation of the welfare function. We show that welfare is affected by the volatility of inflation and the output gap, as in the benchmark case with frictionless financial markets. However, it is also affected by the volatility of the nominal interest rate and of the credit spread. As a result, the target rule which would characterise optimal policy under discretion ought to include a reaction to credit spreads and the nominal interest rate. Third, we show that, in our model, an aggressive easing of monetary policy is optimal in response to an adverse financial market shock that increases the credit spread. The main reason is that this shock generates an undesirable fall in household consumption. The marked easing of monetary policy is aimed at smoothing household consumption. At the same time, the upward pressure on inflation generated by the interest rate cut through higher aggregate demand is attenuated by the direct negative effect on marginal costs. Both inflation and household consumption move less than they would under a Taylor rule. ECB Working Paper Series No 1043 April 2009 5 $*(%+* %$ 8AGE4? 54A>F 78IBG8 @H6; 8UBEG GB G;8 4A4?LF<F B9 G;8 NA4A6<4? 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