Optimal Interest Rate rules, Asset Prices and Credit Frictions

We study optimal Taylor-type interest rate rules in an economy with credit mar-ket imperfections. Our analysis builds on the agency cost framework of Carlstrom and Fuerst (1997), which we extend in two directions. First, we embed monopolistic competition and sticky prices. Second, we modify the stochastic structure of the model in order to generate a countercyclical premium on external finance. This is achieved by linking the mean distribution of investment opportunities faced by entrepreneurs to aggregate total factor productivity. We model monetary policy in terms of simple welfare-maximizing interest rate rules. We find that monetary pol-icy should respond to increases in asset prices by lowering interest rates. However, when monetary policy responds strongly to inflation, the marginal welfare gain of responding to asset prices vanishes. Within the class of linear interest rate rules that we analyze, a strong anti-inflationary stance always attains the highest level of welfare. JEL Classification Number: E52, F41. Keywords: Optimal simple interest rate rules, credit frictions, price stickiness, asset prices. ∗This is an extensively revised version of our CEPR DP 4880. We thank for comments the editor and two anonymous referees. We also thank Fiorella de Fiore, Harris Dellas, Jordi Galí, Marc Giannoni, Stephanie Schmitt-Grohe, Michael Woodford and participants to seminars at the Bank of England, Pom