Optimal interest rate rules, asset prices, and credit frictions

We study optimal Taylor-type interest rate rules in an economy with credit market imperfections. Our analysis builds on the agency cost framework of Carlstrom and Fuerst [1997. Agency costs, net worth and business fluctuations: a computable general equilibrium analysis. American Economic Review 87, 893-910], 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 policy 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. (C) 2006 Elsevier B.V. All rights reserved.