Journal Article

Optimal Interest Rate Rules, Asset Prices and Credit Frictions

Journal of Economic Dynamics and Control

We study optimal Taylor-type interest rate rules in an economy with credit market

imperfections. Our analysis builds on the agency cost framework of Carlstrom

and Fuerst (1997), which we extend in two directions. First, we embed monopolistic

competition and sticky prices. Second, we modify the stochastic structure of the

model in order to generate a countercyclical premium on external finance. This

is achieved by linking the mean distribution of investment opportunities faced by

entrepreneurs to aggregate total factor productivity. We model monetary policy in

terms of simple welfare-maximizing interest rate rules. We find that monetary policy

should respond to increases in asset prices by lowering interest rates. However,

when monetary policy responds strongly to inflation, the marginal welfare gain of

responding to asset prices vanishes. Within the class of linear interest rate rules

that we analyze, a strong anti-inflationary stance always attains the highest level of

welfare.

Authors

Ester Faia
Tommaso Monacelli

Info

Publication Date
JEL Classification
E52, F41