Optimal Monetary Policy in a Financially Fragile Economy

This paper studies optimal monetary policy in an economy where …rms use external funds to …nance operational costs. It is shown that direct and indirect cost channels for monetary policy arise when …rms can default on borrowed funds. The direct cost channel calls for milder contractions in the face of in‡ationary pressures. The indirect cost channel, on the other hand, encourages policy conservatism and suggests stringent anti-in‡ationary measures. It is found that a super-inertial interest rate feedback rule can implement the globally optimal plan as the unique rational expectations equilibrium. JEL classi…cation: E52; E44; E53 Keywords: Optimal Monetary Policy; Default Risk; Cost Channel; Equilibrium Determinacy University of Colorado at Boulder, Department of Economics, 256 UCB, Boulder, CO, 80309, USA, tel: (303) 492 2585, email:[email protected]. I would like to thank Pavel Kapinos, Wolfgang Keller, Robert King, Jinill Kim and, especially, Martin Boileau for helpful comments. I have also bene…ted from comments by session participants at the 2007 conference of the Society for Computational Economics, 2007 Midwest Macro Conference and the 2007 annual meetings of the Eastern Economic Association.