DP7419 Monetary Policy and the Financing of Firms

Author(s): Fiorella De Fiore, Pedro Teles, Oreste Tristani
Publication Date: August 2009
Keyword(s): bankruptcy costs, debt deflation, Financial stability, optimal monetary policy, price level volatility, stabilization policy.
JEL(s): E20, E44, E52
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=7419

How should monetary policy respond to changes in financial conditions? In this paper we consider a simple model where firms are subject to idyosincratic shocks which may force them to default on their debt. Firms' assets and liabilities are denominated in nominal terms and predetermined when shocks occur. Monetary policy can therefore affect the real value of funds used to finance production. Furthermore, policy affects the loan and deposit rates. We find that maintaining price stability at all times is not optimal; that the optimal response to adverse financial shocks is to lower interest rates, if not at the zero bound, and engineer a short period of inflation; that the Taylor rule may implement allocations that have opposite cyclical properties to the optimal ones.