Monetary policymakers typically face uncertainty about key relationships describing the economy. Uncertainty potentially disguises the true economic model that governs the economy, disturbs parameters, and introduces noise into the data series available to the policymaker.
This paper focuses on the consequences of uncertainty about the supply side effect of monetary policy. Firms rely on borrowing working capital from financial intermediaries. As a consequence, credit conditions affect firms’ cost side. The impact of interest rate changes on the cost of acquiring and holding working capital is referred to as the cost channel. Recently, Ravenna and Walsh (2006) derive optimal monetary policy in the presence of a cost channel.
To the extent that deregulation, financial integration, and, most importantly, the cyclical nature of financial frictions affect the credit conditions for firms, the central bank is likely to not be perfectly informed about the true size of the cost channel. Complete knowledge would require a full understanding of how commercial banks pass-through interest rate changes to their customers and how credit conditions in general change after, say, a monetary tightening. In particular, the recent banking turmoil in 2007/08, that evolved into a full-blown financial crisis, raised concerns about firms’ access to credit markets and their ability to borrow working capital to finance ongoing production.
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Optimal Monetary Policy with an Uncertain Cost Channel
