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Title: Credit Frictions and Optimal Monetary Policy

Author(s): Vasco C�rdia and Michael Woodford

Publication Date: December 2015

Keyword(s): credit spreads, flexible inflation targeting, policy rules, quadratic loss function and target criterion

Programme Area(s): International Macroeconomics and Finance and Monetary Economics and Fluctuations

Abstract: We extend the basic (representative-household) New Keynesian [NK] model of the monetary transmission mechanism to allow for a spread between the interest rate available to savers and borrowers, that can vary for either exogenous or endogenous reasons. We find that the mere existence of a positive average spread makes little quantitative difference for the predicted effects of particular policies. Variation in spreads over time is of greater significance, with consequences both for the equilibrium relation between the policy rate and aggregate expenditure and for the relation between real activity and inflation. Nonetheless, we find that the target criterion?a linear relation that should be maintained between the inflation rate and changes in the output gap?that characterizes optimal policy in the basic NK model continues to provide a good approximation to optimal policy, even in the presence of variations in credit spreads. Such a flexible inflation target" can be implemented by a central-bank reaction function that is similar to a forward-looking Taylor rule, but adjusted for changes in current and expected future credit spreads

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Bibliographic Reference

C�rdia, V and Woodford, M. 2015. 'Credit Frictions and Optimal Monetary Policy'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=11016