How should monetary policy respond to changes in financial conditions? We consider a simple model where firms are subject to shocks which may force them to default on their debt. Firms' assets and liabilities are nominal and predetermined. Monetary policy can
therefore affect the real value of funds used to finance production. In
this model, allowing for inflation volatility in response to aggregate
shocks can be optimal; the optimal response to adverse financial shocks is to lower interest rates and to engineer some inflation; and the Taylor rule may implement allocations that have opposite cyclical properties to the optimal ones. (JEL G32, E31, E43, E44, E52)
De Fiore, Fiorella, Pedro Teles, and Oreste Tristani.
"Monetary Policy and the Financing of Firms."
American Economic Journal: Macroeconomics,
Price Level; Inflation; Deflation
Interest Rates: Determination, Term Structure, and Effects
Financial Markets and the Macroeconomy
Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure