Working Paper

Optimal Monetary Policy with Credit Augmented Liquidity Cycles

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 a 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.

Author

Ester Faia

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Publication Date
JEL Classification
E0, E4, E5, E6