Working Paper

Leverage, investment, and optimal monetary policy

Abstract: We study optimal monetary policy in an economy where firms? debt overhangs lead to under-investment and under-production. The magnitude of this debt-induced distortion varies over the business cycle, rising significantly during recessions. When debt is contracted in nominal terms, this distortion gives rise to a balance sheet channel for monetary policy. In the presence of real and financial shocks, the monetary authority faces a trade-off between inflation and output gap stabilization. The optimal monetary policy rule prescribes that the anticipated component of inflation should be set equal to a target level, while the unanticipated component should rise in response to adverse shocks, smoothing the debt overhang distortion and the output gap.

Keywords: Business cycles; Monetary policy;

https://doi.org/10.26509/frbc-wp-201238

Bibliographic Information

Provider: Federal Reserve Bank of Cleveland

Part of Series: Working Papers (Old Series)

Publication Date: 2012

Number: 1238