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Optimal Monetary Policy in a Financially Fragile Economy

Author

Listed:
  • Demirel Ufuk D

    (University of Colorado at Boulder)

Abstract
This paper studies optimal monetary policy in an economy where firms rely heavily on external funds to finance operational costs. In the model, financial contracts are subject to agency problems and firms can possibly default on borrowed funds. Financial frictions have two separate effects on the model. First, they introduce an indirect cost channel to the monetary transmission mechanism. Second, they exacerbate the welfare costs of output gap fluctuations. The indirect cost channel implies that a given reduction in inflation can be achieved with a smaller output loss. This effect encourages the policy maker to emphasize inflation stabilization. At the same time, agency costs also make output gap fluctuations more costly in terms of economic welfare. This second effect encourages the policy maker to place more emphasis on output gap stabilization. Whether the optimal policy requires greater inflation stabilization or output gap stabilization depends on the balance of these two effects. Under a reasonable parametrization, the first effect dominates the second and the optimizing policy maker adopts a stricter anti-inflationary stance.

Suggested Citation

  • Demirel Ufuk D, 2009. "Optimal Monetary Policy in a Financially Fragile Economy," The B.E. Journal of Macroeconomics, De Gruyter, vol. 9(1), pages 1-37, May.
    • Handle: RePEc:bpj:bejmac:v:9:y:2009:i:1:n:15
    DOI: 10.2202/1935-1690.1857
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    References listed on IDEAS

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    2. Paul Kitney, 2016. "Financial factors and monetary policy: Determinacy and learnability of equilibrium," CAMA Working Papers 2016-41, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
    3. Fang‐Shuo Chang & Shiu‐Sheng Chen & Po‐Yuan Wang, 2020. "Politics and the UK's monetary policy," Scottish Journal of Political Economy, Scottish Economic Society, vol. 67(5), pages 486-522, November.
    4. Demirel, Ufuk Devrim, 2010. "Macroeconomic stabilization in developing economies: Are optimal policies procyclical?," European Economic Review, Elsevier, vol. 54(3), pages 409-428, April.
    5. William John Tayler & Roy Zilberman, 2019. "Unconventional Policies in State-Contingent Liquidity Traps," Working Papers 257107351, Lancaster University Management School, Economics Department.
    6. Martina Cecioni & Giuseppe Ferrero & Alessandro Secchi, 2018. "Unconventional Monetary Policy in Theory and in Practice," World Scientific Book Chapters, in: Douglas D Evanoff & George G Kaufman & A G Malliaris (ed.), Innovative Federal Reserve Policies During the Great Financial Crisis, chapter 1, pages 1-36, World Scientific Publishing Co. Pte. Ltd..
    7. König, Tobias, 2024. "The financial accelerator, wages, and optimal monetary policy," Journal of International Money and Finance, Elsevier, vol. 148(C).
    8. Tweneboah Senzu, Emmanuel, 2019. "Theoretical perspective of dynamic credit risk analysis and lending model; effective to enterprises of fragile economy," MPRA Paper 91789, University Library of Munich, Germany.
    9. Tweneboah Senzu, Emmanuel, 2022. "The Philosophical interpretation of Fragility as an Economics concept," MPRA Paper 112736, University Library of Munich, Germany.
    10. Demirel, Ufuk Devrim, 2013. "Gains from commitment in monetary policy: Implications of the cost channel," Journal of Macroeconomics, Elsevier, vol. 38(PB), pages 218-226.
    11. Tayler, William J. & Zilberman, Roy, 2021. "Optimal Loan Loss Provisions and Welfare," Journal of Macroeconomics, Elsevier, vol. 69(C).

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