Credit Frictions and Optimal Monetary Policy

Authors

Michael Woodford

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2015-20 | December 1, 2015

We extend the basic (representative-household) New Keynesian model of the monetary transmission mechanism to allow for a spread between the interest rate available to savers and borrowers. We find variation in these spreads over time has consequences both for the equilibrium relation between the policy rate and aggregate expenditure and for the relation between real activity and inflation. Nonetheless, the target in the basic model provides a good approximation to optimal policy. 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.

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Article Citation

Woodford, Michael, and Vasco Curdia. 2015. “Credit Frictions and Optimal Monetary Policy,” Federal Reserve Bank of San Francisco Working Paper 2015-20. Available at https://doi.org/10.24148/wp2015-20

About the Author
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Vasco Cúrdia is a research advisor in the Economic Research Department of the Federal Reserve Bank of San Francisco. Learn more about Vasco Cúrdia