Federal Reserve Bank of Dallas Globalization and Monetary Policy Institute Credit Risks and Monetary Policy Trade-off's

Financial frictions and financial shocks can affect the trade-off between inflation stabilization and output-gap stabilization faced by a central bank. Financial frictions lead to a greater response in output following any deviation of inflation from target and thus lead to an increase in the sacrifice ratio. As a result, optimal monetary policy in the face of credit frictions is to allow greater output gap instability in return for greater inflation stability. Such a shift in optimal monetary policy can be mimicked in a Taylor-type interest rate feedback rule that shifts weight to inflation and the lagged interest rate and away from output. However, the ability of the conventional Taylor rule to mimic optimal policy gets worse as credit market frictions and shocks intensify. By including a financial variable like the lending spread in the monetary policy rule, the central bank can partially reverse this worsening output-inflation trade-off brought about by financial frictions and partially undo the effects of credit market frictions and shocks. Thus the central bank may want to include lending spreads in the policy rule even when financial distortions are not explicitly part of the central bank’s objective function. JEL codes: E32, E44, E50, G01 * Scott Davis, Globalization and Monetary Policy Institute, Federal Reserve Bank of Dallas, 2200 N. Pearl Street, Dallas, TX 75201. 214-922-5124. [email protected]. Kevin X.D. Huang, Vanderbilt University, VA Station B #35189, 2301 Vanderbilt Place, Nashville, TN 37235-1819. 615-936-7271. [email protected]. An earlier version of this paper was circulated under the title "Optimal Monetary Policy under Financial Sector Risk." For helpful comments and suggestions, we thank audiences at the 2011 Midwest Macroeconomics Meetings, the 2011 Shanghai Macroeconomics Workshop, the 2011 World Congress of the International Economic Association, and the 2012 Federal Reserve Bank of Dallas Conference on Financial Frictions and Monetary Policy in an Open Economy, especially our discussant, Césaire Meh, and seminar participants at the Federal Reserve Bank of Boston, the Huazhong University of Science and Technology, the University of Southern California, and Wuhan University. The views in this paper are those of the authors and do not necessarily reflect the views of the Federal Reserve Bank of Dallas or the Federal Reserve System.