Marco Airaudo

“Optimal monetary policy with counter-cyclical credit spreads”

Abstract

We study the consequences for monetary policy design of including deep habits in credit markets into the benchmark New-Keynesian DSGE model. Under deep habits, monopolistically competitive banks set lending rates in a forward-looking fashion: they internalize the fact that, due to habits in banking (which are meant to capture borrowers’ switching costs and therefore, persistence in bank lending relationships), current interest rates affect also future demand of loans by financially constrained firms. We find that the stronger is the role of deep-habits, the larger the departure of optimal monetary policy (both under discretion and under commitment) from the efficient allocation, and hence from price stability. The welfare costs of setting monetary policy under discretion (i.e. of not committing to an optimal Ramsey plan) are strictly increasing in the extent of deep habits and can be sizable.