“Credit Frictions and Optimal Monetary Policy”
by Vasco Cúrdia and Michael Woodford

Discussion by Miles KimballMay 28, 2008
Bank of Japan ConferenceSix Conclusions of the Paper
1.

Financial frictions and financial shocks can be
assimilated smoothly into the Basic New KeynesianModel. (A major accomplishment. More intuition?)
2 and 3. The main focus should be on the vector of interest
rates, not monetary or credit aggregates.
4. There may be a failure of Ricardian equivalence
because government borrowing has smaller credit
frictions than private borrowing….
5. To a large extent, a weighted average of interest rates
takes on the role of the single interest rate in simpler
models. Thus, an interest rate rule for any interest rateother than this average should adjust for creditspreads. (But should not target credit spreads!)
6. Flexible inflation targeting is still optimal.

Key Issues for Discussion—
All Broader than this Paper• Investment and other durables• Long-term versus short-term interest rates• The relative weight of inflation stabilizationand output gap stabilization.

Given Half a Chance, Investment
and Other Durables do the Heavy
Lifting in Business Cycle Models• Traditional view of business cycles: consumption
are a bigger share of the level, but I and durable
fluctuations are a big share of the fluctuations ofoutput. (Romer: 65.2% of recession fall in Y)• Investment is central to Real Business Cyclemodels. (I/Y and N)• Barsky-House-Kimball (June 2007 AER):
monetary neutrality if investment and durable
prices are not sticky, regardless of sticky prices
for nondurables.
• Credit frictions and investment.

What Difference Would Investment
and Durables Make to CúrdiaWoodford?
• Because much borrowing is for investment anddurables, the elasticity of intertemporal
substitution for borrowers will be much higher
than for savers.
• Thus, the appropriate weighted average ofinterest rates to focus on is close to theborrowing rate for investment and durables.
This makes reducing the Fed Funds rate 1 for 1
with the credit spread look better.

Why are Investment and Durablesin the Background in Interest andPrices and in Cúrdia-Woodford?
1. Infinite capital adjustment cost limit
2. High, but finite adjustment costs mean
investment can be treated likeconsumption.
3. Desire to block strong redirection ofinvestment between firms with different
sticky prices.

The Low-Adjustment-Cost
Benchmark (Neomonetarist Model)• Very high responsiveness of investment and durables tointerest rates.
• The economic structure of investment and durables
dominates the behavior of the economy, regardless ofthe economic structure for nondurables.
• Short-term gap between R-δ and r governs fluctuations
via the delay condition, not long-term interest rates.
(This implies that one of the few cogent arguments forinterest-rate smoothing goes away.)• The counterpart to the IS curve (the KE curve) isupward-sloping. This means the monetary policy rule
must raise r with Y for stability.

The KE (Net Rental Rate) Curver(No Investment Smoothing Case)r=[α/(1-α)](WN/K)-δ
Derivation:r=R-δ
(no investment smoothing)
RK/WN=α/(1-α) (constant cost shares )N=Y1/γ(1-α)K-α/(1-α)Z-1 (IRTS Cobb Douglas
production function)
W=–UN/UC = W(N(Y,K,Z),λ) (labor supply)KE

r=0–YYmin(I=Imin)r

Short Run EquilibriaMPKEr=0––πeY
Ymin(I=Imin)

YnaturalHow High are Adjustment Costs?
• Probably right in the middle, exactly where thedramatic transition between the intuition of thetwo benchmark cases is taking place. We needto know.
• Time-to-build, time-to-plan, planning adjustment
costs, lumpy investment and sticky information
all can contribute to the appearance ofadjustment costs, but have different implications
than Q-theory-type capital adjustment costs. (cf.
Jonathan Millar)• Thus, not simple to calibrate. It deserves aserious research agenda.

Modeling tasks to bring durable
varieties into sticky-price models• Standard treatment of durables or investment insticky price models can only be justified if thevarieties are nondurable before aggregation into
the durable.
• Durable varieties mean that the fixed costs
behind increasing returns to scale cannot be
flow fixed costs.
• Durable goods monopoly problem.
**********************************************************
In general, putting investment and durables into
the model changes everything, unlessadjustment costs are high.

Output Gap Stabilization
vs. Inflation Stabilization• Presumably, the strong weight on inflation stabilization in
the approximate quadratic objective function comes froma high price elasticity of demand for each variety.
– Implies huge fluctuations in relative quantities of the different
varieties if aggregate (and therefore relative) prices move much.

• The often-used Basu-Fernald markup ratio estimate of1.1, implying a price elasticity of demand equal to 11, isby a methodology that yields .6 for some sectors.
– Worst factors used last.
– OK for some purposes, but not for identifying the price elasticity
of demand.
– 1.1+.4 = 1.5 Æ price elasticity of demand = 3.

• Quite plausible that the short-run price elasticity ofdemand < longer run price elasticity of the markup.

Bottom Line• Skillful, smooth addition of financial frictions to the New
Keynesian Model.
• Other than the need to focus on something close to theborrowing rate for investment and durables, the results
are reassuringly familiar.
• Talking about financial frictions points to the huge issueof investment and durables in sticky price models. It is
the right time to pursue that research agenda.
• The research agenda of studying investment anddurables in sticky price models (over the full range ofpossible parameter values) is worthy of the best minds inbusiness cycle theory, including Cúrdia and Woodford.