Imperfect credit markets: implications for monetary policy

Vlieghe, Gertjan W (2007): Imperfect credit markets: implications for monetary policy.

Abstract

I develop a model for monetary policy analysis that features significant feedback from asset prices to macroeconomic quantities. The feedback is caused by credit market imperfections, which dynamically affect how efficiently labour and capital are being used in aggregate. I then analyse what implications this mechanism has for monetary policy. The paper offers three insights. First, the monetary transmission mechanism works not only via nominal rigidites but also via a reallocation of productive resources away from the most productive agents. Second, following an adverse productivity shock there is a dynamic trade-off between the immediate fall in output, which is an effcient response to the productivity fall, and the fall in output thereafter, which is caused by a reallocation of resources away from the most productive agents. The more the initial output fall is dampened with a temporary rise in inflation, the more the adverse future effects of the reallocation of resources are mitigated. Third, in a full welfare-based analysis of optimal monetary policy I show that it is optimal to have some inflation variability, even if the only shocks in the economy are productivity shocks. The optimal variability of inflation is small, but the costs of stabilising inflation too aggressively can be large.

• Item Type: MPRA Paper
• Language: English
• Keywords: monetary policy; credit frictions; credit crunch; optimal monetary policy
• Subjects: E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit; E - Macroeconomics and Monetary Economics > E3 - Prices, Business Fluctuations, and Cycles

References

Alvarez, F., and Jermann, U. J. Efficiency, equilibrium, and asset pricing with risk of default. Econometrica 68, 4 (2000), 775–798.

Angeletos, G.-M. Optimal monetary and fiscal policy: A linear-quadratic approach (comment). NBER Macroeconomics Annual 2003 (2003), 350–361.

Aoki, K. Optimal monetary policy responses to relative-price changes. Journal of Monetary Economics 48, 1 (2001), 55–80.

Barlevy, G. Credit market frictions and the allocation of re sources over the business cycle. Journal of Monetary Economics 50, 8 (2003), 1795–1818.

Basu, S., and Fernald, J. G. Returns to scale in u.s. production: Estimates and implications. Journal of Political Economy 105, 2 (1997), 249–283.

Bernanke, B., and Gertler, M. Agency costs, net worth, and business fluctuations. American Economic Review 79, 1 (1989), 14–31.

Bernanke, B., Gertler, M., and Gilchrist, S. The financial accelerator in a quantitative business cycle framework. Handbook of Macroeconomics 1C (1999), 1341–1393.

Bernanke, B. S., and Gertler, M. Should central banks respond to movements in asset prices? American Economic Review 91, 2 (2001), 253–257.

Blanchard, O. Inflation targeting in transition economies: A comment. In The Inflation-Targeting Debate, B. Bernanke and M. Woodford, Eds. University of Chicago Press, Chicago, 2005.

Blanchard, O., and Kahn, C. M. The solution of linear dif- ference models under rational expectations. Econometrica 48, 5 (1980), 1305–1311.

Brock, W. A., and Mirman, L. Optimal economic growth and uncertainty: The discounted case. Journal of Economic Theory 4 (1972), 479–513.

Calvo, G. Staggered prices in a utility-maximizing framework. Journal of Monetary Economics 12, 3 (1983), 383–398.

Carlstrom, C. T., and Fuerst, T. S. Agency costs, net worth, and business fluctuations: A computable general equilibrium analysis. American Economic Review 87, 5 (1997), 893–910.

Carlstrom, C. T., and Fuerst, T. S. Agency costs and business cycles. Economic Theory 12, 3 (1998), 583–597.

Chari, V. V., Kehoe, P. J., and McGrattan, E. R. Business cycle accounting. NBER Working Paper, 10351 (2004).

Cooley, T. F., Marimon, R., and Quadrini, V. Aggregate consequences of limited contract enforceability. Journal of Political Economy 112 (2004), 817–847.

Cooley, T. F., and Prescott, E. C. Economic growth and business cycles. In Frontiers of Business Cycle Research, T. F. Cooley, Ed. Princeton University Press, Princeton, 1995, pp. 1–39.

Cordoba, J.-C., and Ripoll, M. Credit cycles redux. International Economic Review 45, 4 (2004), 1011–1046.

Dixit, A. K., and Stiglitz, J. E. Monopolistic competition and optimum product diversity. American Economic Review 67, 3 (1977), 297–308.

Eisfeldt, A. L., and Rampini, A. A. Capital reallocation and liquidity. Northwestern University Working Paper (2005).

Erceg, C. J., Henderson, D. W., and Levin, A. T. Optimal monetary policy with staggered wage and price contracts. Journal of Monetary Economics 46, 2 (2000), 281–313.

Faia, E., and Monacelli, T. Optimal interest rate rules, asset prices and credit frictions. Universitat Pompeu Frabra Working Paper (2004).

Fisher, I. The debt-deflation theory of great depressions. Econometrica 1, 4 (1933), 337–357.

Gertler, M. Financial structure and aggregate economic activity: An overview. Journal of Money, Credit and Banking 20, 3 (1988), 559–588.

Gilchrist, S., and Leahy, J. V. Monetary policy and asset prices. Journal of Monetary Economics 49, 1 (2002), 75–97.

Hamilton, J. D. Time Series Analysis. Princeton University Press, Princeton, NJ, 1994.

Hubbard, R. G. Capital-market imperfections and investment. Journal of Economic Literature 36, 1 (1998), 193–225.

Iacoviello, M. House prices, borrowing constraints and mone- tary policy in the business cycle. American Economic Review 95, 3 (2005), 739–764.

Jaffee, D. M., and Russell, T. Imperfect information, un- certainty, and credit rationing. Quarterly Journal of Economics 90, 4 (1976), 651–666.

Jermann, U., and Quadrini, V. Stock market boom and the productivity gains of the 1990s. NBER Working Paper, 9034 (2002).

Kehoe, T. J., and Levine, D. K. Debt-constrained asset mar- kets. Review of Economic Studies 60, 4 (1993), 865–888.

Kehoe, T. J., and Prescott, E. C. Great depressions of the twentieth century. Review of Economic Dynamics 5, 1 (2002), 1–18.

Kiyotaki, N. Credit and business cycles. Japanese Economic Review 49, 1 (1998), 18–35.

Kiyotaki, N., and Moore, J. Credit cycles. Journal of Political Economy 105, 2 (1997), 211–248.

Kocherlakota, N. R. Implications of efficient risk sharing without commitment. Review of Economic Studies 63, 4 (1996), 595–609.

Kocherlakota, N. R. Creating business cycles through credit constraints. Federal Reserve Bank of Minneapolis Quarterly Review 24, 3 (2000), 2–10.

Ljungqvist, L., and Sargent, T. J. Recursive Macroeconomic Theory, second edition ed. MIT Press, Cambridge, MA, 2004.

McCallum, B. T. Price level determinacy with an interest rate policy rule and rational expectations. Journal of Monetary Economics 8, 3 (1981), 319–329.

Plosser, C. I. Understanding real business cycles. Journal of Economic Perspectives 3, 3 (1989), 51–77.

Prescott, E. C. Theory ahead of business cycle measure- ment. Federal Reserve Bank of Minneapolis Quarterly Review, Fall (1986), 9–22.

Prescott, E. C. Needed: A theory of total factor productivity. International Economic Review 39, 3 (1998), 525–51.

Rotemberg, J. J. Sticky prices in the united states. Journal of Political Economy 90 (1982), 1187–1211.

Sargent, T. J. Dynamic Macroeconomic Theory. Harvard Uni- versity Press, Cambridge, MA, 1987.

Sargent, T. J., and Wallace, N. ”rational” expectations, the optimal monetary instrument, and the optimal money supply rule. Journal of Political Economy 83, 2 (1975), 241–254.

Sbordone, A. M. Prices and unit labor costs: a new test of price stickiness. Journal of Monetary Economics 49, 2 (2002), 265–292.

Scheinkman, J. A., and Weiss, L. Borrowing constraints and aggregate economic activity. Econometrica 54, 1 (1986), 23–45.

Schiantarelli, F. Financial constraints and investment: Methodological issues and international evidence. Oxford Review of Economic Policy 12, 2 (1996), 70–89.

Schmitt-Grohe, S., and Uribe, M. Optimal fiscal and mone- tary policy under sticky prices. Journal of Economic Theory 114, 2 (2004), 198–230.

Schmitt-Grohe, S., and Uribe, M. Solving dynamic general equilibrium models using a second-order approximation to the policy function. Journal of Economic Dynamics and Control 28, 4 (2004), 755–775.

Soderlind, P. Solution and estimation of re macromodels with optimal policy. European Economic Review 43, 4-6 (1999), 813–823.

Stiglitz, J. E., and Weiss, A. Credit rationing in markets with imperfect information. American Economic Review 71, 3 (1981), 393–410.

Taylor, J. B. Discretion versus policy rules in practice. Carnegie-Rochester Conference Series on Public Policy 39 (1993), 195–214.

Woodford, M. Interest and Prices. Princeton University Press, Princeton, NJ, 2003.