Lending Relationships and Monetary Policy. Birkbeck wp in economics & nance 0912

Financial intermediation and actual versus policy short term interest rates are important elements in the analysis of business cycle transmission and monetary pol-icy. We present a simple framework that introduces lending relationships, a relevant feature of financial intermediation that has been so far neglected in the monetary economics literature, into a dynamic stochastic general equilibrium model with stag-gered prices and cost channels. Our main findings are: (i) banking spreads move countercyclicaly generating amplified output responses, (ii) spread movements are important for monetary policy making even when a standard Taylor rule is employed (iii) modifying the policy rule to include a banking spread adjustment improves sta-bilization of shocks and increases welfare when compared to rules that only respond to output gap and inflation, and finally (iv) the presence of strong lending relation-ships in the banking sector can lead to indeterminacy of equilibrium forcing the central bank to react to spread movements