Banks, their Balance Sheets and Optimal Monetary Policy

We incorporate financial constraints in a standard dynamic new Keynesian model. These constraints are derived endogenously from two moral hazard problems in financial markets: Unobservable project choice of entrepreneurs generates a role for entrepreneurial net worth in financial contracts, while unobservable monitoring by commercial banks gives rise to bank capital as a determinant in aggregate lending. We study the transmission of shocks to monetary policy and bank capital and total factor productivity. Furthermore, we analyze optimal monetary policy. It is shown that interest rate rules should not respond to asset prices or loan supply. Optimal monetary policy does not fully stabilize the inflation rate in response to shocks. However, the optimal amount of volatility in the inflation rate is extremely small. Key words: Banks; moral hazard; financial market imperfections; Ramsey JEL classification: E44; E32; E52