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Optimal Monetary Policy with Credit Augmented Liquidity Cycles

Author

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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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    References listed on IDEAS

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    6. 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.
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    9. 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.
    10. 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.
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    Cited by:

    1. 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.
    2. Cacciatore, Matteo & Ghironi, Fabio, 2021. "Trade, unemployment, and monetary policy," Journal of International Economics, Elsevier, vol. 132(C).
    3. Marco Riguzzi & Philipp Wegmueller, 2017. "Economic Openness and Fiscal Multipliers," International Economic Journal, Taylor & Francis Journals, vol. 31(1), pages 1-35, January.
    4. Tillmann, Peter, 2009. "The time-varying cost channel of monetary transmission," Journal of International Money and Finance, Elsevier, vol. 28(6), pages 941-953, October.
    5. Fiorella De Fiore & Oreste Tristani, 2013. "Optimal Monetary Policy in a Model of the Credit Channel," Economic Journal, Royal Economic Society, vol. 123(571), pages 906-931, September.
    6. Kutu Adebayo Augustine & Ngalawa Harold, 2017. "Monetary Policy and Industrial Output in the BRICS Countries: A Markov-Switching Model," Folia Oeconomica Stetinensia, Sciendo, vol. 17(2), pages 35-55, December.
    7. Claudio Cesaroni, 2017. "Optimal Long-Run Inflation and the Informal Economy," Bank of Lithuania Working Paper Series 46, Bank of Lithuania.
    8. Peter Tillmann, 2009. "Optimal Monetary Policy with an Uncertain Cost Channel," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 41(5), pages 885-906, August.

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