DP4880 | Optimal Monetary Policy Rules, Asset Prices and Credit Frictions

Publication Date

23/01/2005

JEL Code(s)

Keyword(s)

Programme Area(s)

Network(s)

Abstract

We study optimal monetary policy in two prototype economies with sticky prices and credit market frictions. In the first economy, credit frictions apply to the financing of the capital stock, generate acceleration in response to shocks and the ?financial markup? (i.e., the premium on external funds) is countercyclical and negatively correlated with the asset price. In the second economy, credit frictions apply to the flow of investment, generate persistence, and the financial markup is procyclical and positively correlated with the asset price. We model monetary policy in terms of welfare-maximizing interest rate rules. The main finding of our analysis is that strict inflation stabilization is a robust optimal monetary policy prescription. The intuition is that, in both models, credit frictions work in the direction of dampening the cyclical behaviour of inflation relative to its credit-frictionless level. Thus neither economy, despite yielding different inflation and investment dynamics, generates a trade-off between price and financial markup stabilization. A corollary of this result is that reacting to asset prices does not bear any independent welfare role in the conduct of monetary policy.