Ebook Optimal Monetary Policy in a Model of the Credit Channel
Central banks devote much effort to the analysis of the financial positions of households, firms and financial institutions, and to monitor the evolution of credit aggregates and interest rate spreads. One reason is that financial market conditions are perceived to be factors which contribute to shape the performance of the economy and to affect its inflationary prospects.
This perception appears to be consistent with the time series properties of some financial variables. For example, credit spreads in both the US and the euro area display a positive correlation with inflation (see Figure 1). The correlation is suggestive of a possible role for spreads in affecting firmsmmarginal costs. Higher spreads would then be reflected in a causal way into higher prices.
In several historical episodes, central banks have also reacted sharply to changes in financial conditions. One example are the US developments during the late 1980s, when banks experienced large loan losses as a consequence of the bust in the real estate market. Due to weak financial conditions, banks could not raise new capital and, because of the requirement to comply with the Basel Accord, they were forced to cut back on loans. This led to a slowdown in credit growth and aggregate spending. According to Rudebusch (2006), this slowdown contributed to the FOMC decision to reduce the Federal funds rate well below what suggested by an estimated Taylor rule.
A more recent example is provided by the financial market turmoil initiated in 2007 with the deterioration in the performance of nonprime mortgages in the US. In August 2007, the FOMC justified a cut in the discount rate of 50 basis points by expressing concerns about the ongoing deterioration of financial market conditions and tightening of credit conditions, which increased appreciably the downside risks to growth.
To analyze whether financial market conditions ought to have a bearing on monetary policy decisions, we consider a simple extension of the basic New$Keynesian setup, where firms need to borrow funds in advance of production and informational frictions characterize financial markets. As in Bernanke, Gertler and Gilchrist (1989) and Carlstrom and Fuerst (1997, 1998), we assume that firms have private information about the realization of an idiosyncratic productivity shock, which banks can only monitor ex$post at a cost.
The presence of asymmetric information introduces the risk of default on loans, so that banks find it optimal to charge a lending rate which is above their marginal cost (the deposit rate). One deviation from the setup adopted in Bernanke, Gertler and Gilchrist (1989) and Carlstrom and Fuerst (1997, 1998) is that we assume that loans are denominated in nominal prather than real pterms.
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