Output gap, monetary policy trade-offs, and financial frictions

This paper investigates how the presence of pervasive financial frictions and large financial shocks changes the optimal monetary policy prescriptions and the estimated dynamics in a New Keynesian model. We find that financial factors affect the optimal policy only to some extent. A policy of nomina...

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Bibliographic Details
Published in:Review of economic dynamics 2021-07, Vol.41, p.52-70
Main Authors: Furlanetto, Francesco, Gelain, Paolo, Taheri Sanjani, Marzie
Format: Article
Language:English
Subjects:
Financial frictions
Monetary policy
Output gap
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Summary:This paper investigates how the presence of pervasive financial frictions and large financial shocks changes the optimal monetary policy prescriptions and the estimated dynamics in a New Keynesian model. We find that financial factors affect the optimal policy only to some extent. A policy of nominal stabilization (with a particular focus on targeting wage inflation) is still the optimal policy, although the central bank is now unable to fully stabilize economic activity around its potential level. In contrast, the presence of financial frictions and financial shocks crucially changes the size and shape of the estimated output gap and the relative importance of different shocks in driving economic fluctuations, with financial shocks absorbing explanatory power from labor supply shocks.
ISSN:1094-2025
1096-6099
DOI:10.1016/j.red.2020.07.004