Working Paper: CEPR ID: DP11016
Authors: Vasco Curdia; Michael Woodford
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
Keywords: credit spreads; flexible inflation targeting; policy rules; quadratic loss function; target criterion
JEL Codes: E44; E52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| credit spreads (G12) | aggregate expenditure (E10) |
| credit spreads (G12) | monetary policy effectiveness (E52) |
| policy rate adjustments (E52) | economic activity (E20) |
| credit market conditions (E44) | monetary policy effectiveness (E52) |
| optimal monetary policy (E63) | economic activity (E20) |