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Credit frictions and optimal monetary policy C

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Title: Credit frictions and optimal monetary policy C


1
Credit frictions and optimal monetary
policyCúrdia and Woodford
Discussion Frank Smets
Towards an integrated macro-finance framework for
monetary policy analysis Brussels, 16-17 October
2008
2
Summary
  • Nice, elegant (once you get through several pages
    of algebra) extension of the basic New Keynesian
    (NK) model
  • Includes heterogeneous consumers (with different
    saving behaviour) which gives rise to lending and
    borrowing in equilibrium
  • Financial intermediation is costly, giving rise
    to an external finance premium possibility of
    financial mark-up.
  • As a result, the basic NK IS and Phillips curves
    are amended with a term (financial wedge) that
    acts like a cost-push shock.

3
Policy implications
  • The principles of optimal monetary policy are not
    changed much.
  • The NK targeting criteria is still very much in
    place identical with exogenous finance premium
  • What has changed is the transmission process
    financial frictions do affect how shocks and
    policy affect output and inflation
  • However, in the benchmark calibration these
    effects are quite small.
  • So, more or less business as usual.

4
Modification of the IS and Phillips curves
  • A higher wedge (lower deposit rate, higher
    borrowing rate) leads to more consumption by
    lender and less consumption by borrower. As
    lender consumes less, the aggregate effect on
    consumption is typically negative (but small).
  • A higher wedge leads to lower labour supply by
    lenders and more work by borrower. As lenders
    work relatively more, the lower labour supply by
    lenders will dominate in the aggregate (but
    small).

5
Responses to a financial shock
6
What about the role of financial frictions?
7
What about the role of financial frictions?
8
What about the role of financial frictions?
  • Two observations
  • The variation in the interest rate spread is
    minimal in response to all aggregate shocks (only
    a few basis points). Is this just a calibration
    issue and thus solvable or a more fundamental
    problem? In reality, the external finance premium
    is much more volatile.
  • There is a clear positive correlation between the
    interest rate spread and credit. In the data the
    finance premium is countercyclical, there is a
    negative correlation. This will be difficult to
    solve with different calibration.

9
Two main comments
  • The CW form of financial friction does not appear
    compatible with the countercyclical external
    finance premium in the data?
  • The premium is partly modelled as an exogenous
    mark-up and partly as covering an ad-hoc
    cost-function. The intermediation (monitoring)
    costs are a function of the amount of lending.
  • What financial frictions may be appropriate?
  • The financial sector is not explicitly modelled.
    There are no explicit banks that maximise profits
    and face asymmetric information problems, the
    possibility of defaults or capital adequacy
    constraints,

10
Some evidence (Christiano et al, 2008)
  • External finance premium in the euro area
  • Low in booms, high in recessions

11
Alternative financial frictions
  • Financial accelerator and procyclical credit
    worthiness broad balance sheet effect
  • Bank lending channel liquidity and capital of
    banks
  • Risk-taking channel the attitude towards risk is
    procyclical.

12
Broad balance sheet effects
  • Most modelling has focused on broad balance sheet
    effects (BGG, KM, Iacoviello, )
  • Financial accelerator can lead to a
    countercyclical external finance premium
  • Higher productivity, higher profitability, higher
    economic activity, higher asset prices increase
    the net worth of households and firms, which
    reduces the external finance premium,
  • Pro-cyclical creditworthiness
  • A booming economy implies lower risks of default,
    lower risk premia, higher asset prices, and
    lower risk premia.

13
Banks versus firms/households?
  • Normal times limited bank lending channel
    securitisation further reduces this channel.
  • Recently, most of the variation has been in
    premium paid by banks

14
Risk-taking channel
Maddaloni, Peydró-Alcalde and Scopel
(2008) Based on Bank Lending Survey data.
15
Different sectors respond differently
  • Giannoni, Lenza and Reichlin (2008)
  • Large BVAR with money/credit aggregates and
    associated interest rates
  • Some findings
  • Credit to non-financial firms increases following
    a monetary policy tightening credit to
    households falls. See also De Haan et al (2007).
  • Lending rates are sticky
  • Why?

16
Credit Aggregates
Note Dashed lines represent the 68 confidence
interval.
17
Lending rates
Note Dashed lines represent the 68 confidence
interval.
18
Conclusions
  • Elegant paper
  • Financial frictions do not appear to be
    quantitatively important and do not fundamentally
    change the principles of monetary policy
  • Is likely to be model-dependent
  • Other financial frictions (or shocks) are
    necessary to explain the procyclicality of the
    external finance premium
  • Interaction with investment (rather than
    consumption) is missing.
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