Ramsey Monetary Policy With Financial Distortions and the Fisherian Theory of Debt Deflation

I derive welfare maximizing policy for an economy characterized by three distortions: monopolistic

competition, sticky prices and borrowing constraint on capital in the form of a premium

on external finance. Under a zero inflation policy - i.e. which closes the gap - neither the

monopolistic competition distortion - which act as a tax on labor - nor the external finance

premium - which act as a tax on capital - can be offset. Both the product mark-up and the external

finance premium act as countercyclical wedges that allow the policy maker to improve the

flexible price allocation. Optimal monetary policy features a long run inflationary bias which

even more pronounced under non-indexed loan contracts. In the latter case indeed inflation

reduces the outstanding value of nominal debt and the services associated with it. Along the

dynamic optimal policy is characterized by deviations from price stability - e.g. both under

productivity and demand shocks - with an optimal inflation volatility which increases together

with the increase in the external finance premium.