WO R k I N g PA P E R S E R I E S
NO 1043 / APRIL 2009
OPTIMAL MONETARY
POLICY IN A MODEL
OF THE CREDIT
CHANNEL
by Fiorella De Fiore
and Oreste Tristani
WO R K I N G PA P E R S E R I E S
N O 10 4 3 / A P R I L 20 0 9
OPTIMAL MONETARY POLICY
IN A MODEL OF
THE CREDIT CHANNEL 1
by Fiorella De Fiore
and Oreste Tristani 2
In 2009 all ECB
publications
feature a motif
taken from the
€200 banknote.
This paper can be downloaded without charge from
http://www.ecb.europa.eu or from the Social Science Research Network
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
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ISSN 1725-2806 (online)
CONTENTS
Abstract
4
Non-technical summary
5
1 Introduction
6
2 The environment
2.1 Households
2.2 Wholesale firms
2.3 Retail firms
2.4 Monetary policy
2.5 Market clearing
9
10
12
16
18
19
3 The linearized equilibrium conditions
3.1 Impulse responses
20
23
4 Second order welfare approximation
26
5 Optimal policy
5.1 Discretion
5.2 Optimal monetary policy
under commitment
30
30
6 Conclusion
33
Appendices
34
References
42
30
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
4
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Working Paper Series No 1043
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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.
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European Central Bank Working Paper Series
For a complete list of Working Papers published by the ECB, please visit the ECB’s website
(http://www.ecb.europa.eu).
989 “Modelling loans to non-financial corporations in the euro area” by C. Kok Sørensen, D. Marqués-Ibáñez
and C. Rossi, January 2009
990 “Fiscal policy, housing and stock prices” by A. Afonso and R. M. Sousa, January 2009.
991 “The macroeconomic effects of fiscal policy” by A. Afonso and R. M. Sousa, January 2009.
992 “FDI and productivity convergence in central and eastern Europe: an industry-level investigation”
by M. Bijsterbosch and M. Kolasa, January 2009.
993 “Has emerging Asia decoupled? An analysis of production and trade linkages using the Asian international
input-output table” by G. Pula and T. A. Peltonen, January 2009.
994 “Fiscal sustainability and policy implications for the euro area” by F. Balassone, J. Cunha, G. Langenus,
B. Manzke, J. Pavot, D. Prammer and P. Tommasino, January 2009.
995 “Current account benchmarks for central and eastern Europe: a desperate search?” by M. Ca’ Zorzi,
A. Chudik and A. Dieppe, January 2009.
996 “What drives euro area break-even inflation rates?” by M. Ciccarelli and J. A. García, January 2009.
997 “Financing obstacles and growth: an analysis for euro area non-financial corporations” by C. Coluzzi,
A. Ferrando and C. Martinez-Carrascal, January 2009.
998 “Infinite-dimensional VARs and factor models” by A. Chudik and M. H. Pesaran, January 2009.
999 “Risk-adjusted forecasts of oil prices” by P. Pagano and M. Pisani, January 2009.
1000 “Wealth effects in emerging market economies” by T. A. Peltonen, R. M. Sousa and I. S. Vansteenkiste,
January 2009.
1001 “Identifying the elasticity of substitution with biased technical change” by M. A. León-Ledesma,
P. McAdam and A. Willman, January 2009.
1002 “Assessing portfolio credit risk changes in a sample of EU large and complex banking groups in reaction
to macroeconomic shocks” by O. Castrén, T. Fitzpatrick and M. Sydow, February 2009.
1003 “Real wages over the business cycle: OECD evidence from the time and frequency domains” by
J. Messina, C. Strozzi and J. Turunen, February 2009.
1004 “Characterising the inflation targeting regime in South Korea” by M. Sánchez, February 2009.
1005 “Labor market institutions and macroeconomic volatility in a panel of OECD countries” by F. Rumler
and J. Scharler, February 2009.
1006 “Understanding sectoral differences in downward real wage rigidity: workforce composition, institutions,
technology and competition” by P. Du Caju, C. Fuss and L. Wintr, February 2009.
1007 “Sequential bargaining in a new-Keynesian model with frictional unemployment and staggered wage
negotiation” by G. de Walque, O. Pierrard, H. Sneessens and R. Wouters, February 2009.
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1008 “Liquidity (risk) concepts: definitions and interactions” by K. Nikolaou, February 2009.
1009 “Optimal sticky prices under rational inattention” by B. Maćkowiak and M. Wiederholt, February 2009.
1010 “Business cycles in the euro area” by D. Giannone, M. Lenza and L. Reichlin, February 2009.
1011 “The global dimension of inflation – evidence from factor-augmented Phillips curves” by S. Eickmeier
and K. Moll, February 2009.
1012 “Petrodollars and imports of oil exporting countries” by R. Beck and A. Kamps, February 2009.
1013 “Structural breaks, cointegration and the Fisher effect” by A. Beyer, A. A. Haug and B. Dewald,
February 2009.
1014 “Asset prices and current account fluctuations in G7 economies” by M. Fratzscher and R. Straub,
February 2009.
1015 “Inflation forecasting in the new EU Member States” by O. Arratibel, C. Kamps and N. Leiner-Killinger,
February 2009.
1016 “When does lumpy factor adjustment matter for aggregate dynamics?” by S. Fahr and F. Yao,
March 2009.
1017 “Optimal prediction pools” by J. Geweke and G. Amisano, March 2009.
1018 “Cross-border mergers and acquisitions: financial and institutional forces” by N. Coeurdacier,
R. A. De Santis and A. Aviat, March 2009.
1019 “What drives returns to euro area housing? Evidence from a dynamic dividend-discount model” by
P. Hiebert and M. Sydow, March 2009.
1020 “Opting out of the Great Inflation: German monetary policy after the break down of Bretton Woods”
by A. Beyer, V. Gaspar, C. Gerberding and O. Issing, March 2009.
1021 “Rigid labour compensation and flexible employment? Firm-level evidence with regard to productivity
for Belgium” by C. Fuss and L. Wintr, March 2009.
1022 “Understanding inter-industry wage structures in the euro area” by V. Genre, K. Kohn and
D. Momferatou, March 2009.
1023 “Bank loan announcements and borrower stock returns: does bank origin matter?” by S. Ongena
and V. Roscovan, March 2009.
1024 “Funding liquidity risk: definition and measurement” by M. Drehmann and K. Nikolaou, March 2009.
1025 “Liquidity risk premia in unsecured interbank money markets” by J. Eisenschmidt and J. Tapking,
March 2009.
1026 “Do house price developments spill over across euro area countries? Evidence from a global VAR”
by I. Vansteenkiste and P. Hiebert, March 2009.
1027 “Long run evidence on money growth and inflation” by L. Benati, March 2009.
1028 “Large debt financing: syndicated loans versus corporate bonds” by Y. Altunbaș, A. Kara
and D. Marqués-Ibáñez, March 2009.
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1029 “The role of fiscal transfers for regional economic convergence in Europe” by C. Checherita, C. Nickel
and P. Rother, March 2009.
1030 “Forecast evaluation of small nested model sets” by K. Hubrich and K. D. West, March 2009.
1031 “Global roles of currencies” by C. Thimann, March 2009.
1032 “Assessing long-term fiscal developments: a new approach” by A. Afonso, L. Agnello, D. Furceri and R. Sousa,
March 2009.
1033 “Fiscal competition over taxes and public inputs: theory and evidence” by S. Hauptmeier, F. Mittermaier
and J. Rincke, March 2009.
1034 “The role of the United States in the global economy and its evolution over time” by S. Dées
and A. Saint-Guilhem, March 2009.
1035 “The role of labor markets for euro area monetary policy” by K. Christoffel, K. Kuester and T. Linzert,
March 2009.
1036 “Search in the product market and the real business cycle” by T. Y. Mathä and O. Pierrard, March 2009.
1037 “What do asset prices have to say about risk appetite and uncertainty?” by G. Bekaert, M. Hoerova
and M. Scheicher, March 2009.
1038 “Are ‘intrinsic inflation persistence’ models structural in the sense of Lucas (1976)?” by L. Benati, March 2009.
1039 “‘Real Time’ early warning indicators for costly asset price boom/bust cycles: a role for global liquidity”
by L. Alessi and C. Detken, March 2009.
1040 “The external and domestic side of macroeconomic adjustment in China” by R. Straub and C. Thimann,
March 2009.
1041 “An economic capital integrating credit and interest rate risk in the banking book” by P. Alessandri
and M. Drehmann, April 2009.
1042 “The determinants of public deficit volatility” by L. Agnello and R. M. Sousa, April 2009.
1043 “Optimal monetary policy in a model of the credit channel” by F. De Fiore and O. Tristani, April 2009.
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