The macroeconomic events in the latter half of 2008 have sparked renewed interest in the role of financial shocks in the business cycle and the appropriate response of monetary policy to these shocks.
This paper adds to this discussion by formally integrating a model of agency costs into an otherwise standard Dynamic New Keynesian (DNK) model. We do so in such a way that the agency-cost mechanism is quite transparent so that interactions between sticky prices and agency cost distortions are clearly identified. In addition our framework enables us to derive analytical expressions for the model-consistent welfare function.
We study the interaction of agency costs and sticky prices in a simple extension of the standard DNK model. Agency costs are modeled as a constraint on the firm’s hiring of labor as in the hold-up problem of Kiyotaki and Moore (1997). We assume that the entrepreneur’s hiring of one productive factor (labor) is constrained by entrepreneurial net worth. More generally, the constraint proxies for the effect that asset prices have on the ability of firms to finance operations.
Net worth is accumulated over time via purchases of shares that are claims on the profit flow of sticky-price firms that produce the final good. This leads to a natural interplay between price stickiness and collateral constraints. In our setup, monetary policy affects dividends and thus share prices by altering the profit flow of these sticky price firms. Share prices in turn affect the hiring of labor via the collateral constraint.
How should monetary policy be conducted in such an environment? From a public finance perspective, prices stickiness implies that real marginal cost acts like a distortionary subsidy on both factor inputs, while agency costs act like a distortionary tax on only one input (the constrained input). This suggests that a trade off between stabilizing these two distortions may exist. We study this question formally by deriving the quadratic welfare function that is consistent with the underlying model and analyze optimal monetary policy in a linear-quadratic framework.
Inflation and the output gap enter our loss function with the same coefficients as in the standard sticky price model. In addition, agency costs give rise to a new term that captures the variations in the tightness of the collateral constraint and that can be interpreted as a risk premium more generally. Thus, the recent concerns by central banks about credit market tightness and the volatility of risk premia have a counterpart in our welfare based loss function.
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