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Optimal Interest Rate Rules, Asset Prices, and Credit Frictions

In this paper we study optimal Taylor-type interest rate rules in an economy with nominal rigidities and credit market imperfections. Our interest is twofold. First, we aim at driving the attention of the recent literature on a typology of market distortions whose role has been largely neglected in the normative analysis of monetary policy.

This is surprising, considering the increasing emphasis starting with Bernanke and Gertler (1989) placed on financial factors in the study of business cycles. Second, we aim at assessing from a welfare-based perspective the role that asset prices and/or other financial indicators should play in the optimal setting of monetary policy rules.

We model credit frictions following the agency cost framework of Carlstrom and Fuerst (1997) (CF henceforth). Financial imperfections originate from a problem of asymmetric information between an entrepreneur (the borrower) and a fi?nancial intermediary (the lender). The entrepreneur engages in a risky investment activity and seeks resources in excess of internal funds. Since the outcome of the investment activity is private information to the entrepreneur, the latter has an incentive to misreport the same outcome.

This moral hazard problem induces the lender to monitor only the defaulting entrepreneurs, and transfer this implicit cost onto the average cost of credit. The appeal of this frame work is that agency costs are endogenous over the business cycle and default emerges as an equilibrium phenomenon.

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Optimal Interest Rate Rules, Asset Prices, and Credit Frictions