Working Paper: CEPR ID: DP7419
Authors: Fiorella De Fiore; Pedro Teles; Oreste Tristani
Abstract: 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.
Keywords: bankruptcy costs; debt; deflation; financial stability; optimal monetary policy; price level volatility; stabilization policy
JEL Codes: E20; E44; E52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Monetary policy (E52) | Real value of funds used for production (E23) |
| Nominal asset denomination and predetermination of funds (G19) | Real value of funds used for production (E23) |
| Increase in price level (E31) | Real value of funds and wages (J31) |
| Decrease in real value of funds and wages (E31) | Bankruptcy rates (K35) |
| Financial shock (F65) | Leverage (G32) |
| Financial shock (F65) | Bankruptcy rates (K35) |
| Optimal policy (lower interest rates and inflation) (E43) | Bankruptcy rates (K35) |
| Taylor-type rule (C69) | Bankruptcy rates (K35) |