Economic growth is highly correlated with financial development. Financial systems, in turn, are more developed where corruption and the returns to political rent-seeking are less (La Porta & et al. 1997; La Porta 2000; La Porta & et al. 2002; La Porta et al. 2006, 2008). Financial development is neither inevitable nor irreversible. Many countries never sustained dynamic financial systems and, more surprisingly, many that once did ceased doing so (Rajan & Zingales 2003).
A remarkable innovation in the credit risk market in the past ten years has been the development of the credit derivatives market. Credit derivatives are over-the-counter financial contracts whose payoffs are linked to changes in the credit quality of an underlying asset (known as the reference entity).
Since the introduction of these credit protection instruments, the market has grown dramatically and become an important tool for financial institutions to shed or take on credit risk. According to the biennial survey by the British Bankers’ Association, the credit derivatives market grew from a USD 40 billion outstanding notional value in 1996 to an estimated USD 1.2 trillion at the end of 2001, and is expected to zoom up to USD 4.8 trillion by the end of 2004.
The objectives of this paper are: (1) to study the effect of monetary policy on the expectation driven business cycles (Pigou cycles); (2) to find the Ramsey optimal monetary policy for the economy in our model hit by a news shock and compare this Ramsey optimal policy with several simple monetary policy rules. We are particularly interested in studying if central bank can mimic the Ramsey optimal policy by targeting only several macroeconomic variables.
Beaudry and Portier (2004) formalized Pigou (1926)’s idea and defined Pigou cycles as: (i) agents receive signals or news indicating that technology will improve in near future. An optimistic forecast of future technological improvement leads to a boom defined as an increase in aggregate output, employment, investment and consumption, and (ii) the realization that a forecast is too optimistic leads to a recession defined as a fall in all the same aggregate variables. The economy is said to be hit by a news shock. They also illustrate that standard one-sector and two-sector equilibrium models used in the macroeconomic literature can not produce Pigou cycles. Of course, their largest contribution is to find a particular multi-sector model in which Pigou cycles can arise. Their finding is that expectation driven business cycle can arise in neo-classical models when one allows for a sufficiently rich description of inter-sector production technology. In particular, the key assumption giving rise to the Pigou cycle is that non-durable goods and durable goods exhibit enough complementarities in the production of the final goods.
