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Financial Frictions, the Phillips Curve and Monetary Policy

Lieberknecht, Philipp (2018): Financial Frictions, the Phillips Curve and Monetary Policy.

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Abstract

This paper proposes a novel explanation for the missing disinflation after the Global Financial Crisis: The interplay between financial frictions, the Phillips curve and the optimal response by central banks. The structural framework is a tractable financial accelerator New Keynesian DSGE model that allows for closed-form solutions. The presence of financial frictions decreases the slope of the structural Phillips curve via a counter-cyclical credit spread that reduces the pro-cyclicality of marginal costs. This worsens the central bank's trade-off between output gap and inflation stabilization, rendering the former costlier. In this environment, optimal monetary policy is strongly geared towards inflation stabilization, regardless of the policy regime. Following large contractionary shocks, the optimal response by central banks is thus to mitigate disinflation to a large extent.

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