Optimal Monetary Policy in a Credit Economy

This paper investigates the performance of monetary policy rules in a crediteconomy. In particular, the paper considers whether or not performance dependsupon financial market imperfection. For this purpose, the paper analyzes a crediteconomy model incorporating a financial friction into a new Keynesianmacroeconomic model. The answer is yes. First, the central bank should respond tooutput rather than to inflation if the financial market is markedly imperfect.Second, under this market condition, the bank should not adopt policy smoothing.Third, the bank should not respond to inflation as aggressively under financial andwealth distribution shocks as under a common supply shock. The results areexactly the same even if the economy takes account of the stability of nominalinterest rate or if the central bank responds to expected inflation rather thancurrent inflation. The paper therefore does not support inflation targeting as thedominant strategy of monetary policy and suggests instead that, in practice, theTaylor rule might be more appropriate in fragile financial markets