Optimal Monetary Policy Rules, Financial Amplification, and Uncertain Business Cycles

Optimal Monetary Policy Rules, Financial Amplification, and Uncertain Business Cycles

Title : Optimal Monetary Policy Rules, Financial Amplification, and Uncertain Business Cycles
Number : 11/26
Author(s) : Salih Fendoğlu
Language : English
Date : December 2011
Abstract : This paper studies whether financial variables per se should matter for monetary policy. Earlier consensus view -using financial amplification models with disturbances that have no direct effect on credit market conditions- suggests that financial variables should not be assigned an independent role in policy making. Introducing uncertainty, time-variation in cross-sectional dispersion of firms' productive performance, alters this policy prescription. The results show that (i) optimal policy is to dampen the strength of financial amplification by responding to uncertainty (at the expense of creating a mild degree of fluctuations in inflation). Moreover, a higher uncertainty makes the planner more willing to relax the financial constraints. (ii) Credit spreads are a good proxy for uncertainty, and hence, within the class of simple monetary policy rules I consider, a non-negligible response to credit spreads -together with a strong anti-inflationary stance- achieves the highest aggregate welfare possible.
Keywords : Optimal Monetary Policy, Financial Amplification, Uncertainty Shocks
JEL Codes : E44; E52

Optimal Monetary Policy Rules, Financial Amplification, and Uncertain Business Cycles
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