Credit Frictions and Optimal Monetary Policy ∗

We extend the basic (representative-household) New Keynesian [NK] model of the monetary transmission mechanism to allow for a spread between the interest rate available to savers and borrowers, that can vary for either exogenous or endogenous reasons. We find that the mere existence of a positive average spread makes little quantitative difference for the predicted effects of particular policies. Variation in spreads over time is of greater significance, with consequences both for the equilibrium relation between the policy rate and aggregate expenditure and for the relation between real activity and inflation. Nonetheless, we find that the target criterion – a linear relation that should be maintained between the inflation rate and changes in the output gap — that characterizes optimal policy in the basic NK model continues to provide a good approximation to optimal policy, even in the presence of variations in credit spreads. Such a “flexible inflation target” can be implemented by a central-bank reaction function that is similar to a forward-looking Taylor rule, but that includes an adjusted for changes in current and expected future credit spreads. The implications for policy are thus similar in spirit to the kind of spread-adjusted Taylor rule proposed by Taylor (2008) and McCulley and Toloui (2008). ∗Revision of a paper prepared for the BIS annual conference, “Whither Monetary Policy? ” Lucerne, Switzerland, June 26-27, 2008. We would like to thank Andy Atkeson, Olivier Blanchard, Bill Brainard, V.V. Chari, Fiorella DeFiore, Marco Del Negro, Gauti Eggertsson, Simon Gilchrist, Marvin Goodfriend, Charles Goodhart, Miles Kimball, John Leahy, Bennett McCallum, Tommaso Monacelli, Argia Sbordone, Frank Smets and Oreste Tristani for helpful comments, and the NSF for research support of the second author through a grant to the NBER. The views expressed in this paper are those of the authors and do not necessarily reflect positions of the Federal Reserve Bank of New York or the Federal Reserve System. †E-mail : vasco.curdia@ny.frb. org ‡E-mail : michael.woodford@columbia.edu It is common for theoretical evaluations of alternative monetary policies — most notably, the literature that provides theoretical foundations for inflation targeting — to be conducted using models of the monetary transmission mechanism that abstract altogether from financial frictions. There is generally assumed to be a single interest rate — “the interest rate” — that is at once the policy rate that constitutes the operating target for the central bank, the rate of return that all households and firms receive on savings, and the rate at which anyone can borrow against future income. In models with more complete theoretical foundations, this is justified by assuming frictionless financial markets, in which all interest rates (of similar maturity) must be equal in order for arbitrage opportunities not to exist. It is also common to assume a representative household, and firms that maximize the value of their earnings streams to that household, so that there is no need for credit flows in equilibrium in any event; such models imply that a breakdown of credit markets would have no allocative significance. Many of the quantitative DSGE models recently developed in central banks and other policy institutions share these features. Such models abstract from important complications of actual economies, even those that are financially quite sophisticated. Sizeable spreads exist, on average, between different interest rates; moreover, these spreads are not constant over time, especially in periods of financial stress. And “tighter” financial conditions, indicated by increases in the size of credit spreads, are commonly associated with lower levels of real expenditure and employment. This poses obvious questions for the practical application of much work in the theory of monetary policy. If a model is to be calibrated or estimated using time series data, which actual interest rate should be taken to correspond to “the interest rate” in the model? When the model is used to to give advice about how interest rates should respond to a particular type of shock, which actual interest rate (if any) should be made to respond in the way that “the interest rate” does in the model? How large an error is likely to be made by abstracting from credit frictions, with regard to the model’s predictions for the variables that appear in it? Moreover, some questions clearly cannot even be addressed using models that abstract from credit frictions. Most notably, how should a central bank respond to a “financial shock” that increases the size of the spreads resulting from credit frictions? This paper seeks to address these questions by presenting a simple extension of See, for example, Clarida et al., (1999) or Woodford (2003), among many other references. The models of Smets and Wouters (2003, 2007) provide an especially influential example. The current generation of DSGE models has been criticized on this ground by Issing (2006) and Goodhart (2007), among others.