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Monetary Policy and Financial Markets by Michele Boldrin, Washington University in St. Louis, Carlso Garriga, Federal Reserve Bank of St. Louis, and William Gavin, Federal Reserve Bank of St. Louis February 29, 2008 Abstract While some economists (e.g. John Taylor, 1998) attribute the great moderation in the volatility of real economic growth in the United States to better stabilization policy by the Fed, others blame monetary policymakers for exacerbating cycles in financial markets (e.g. ECB paper). Indeed, the New Keynesian model predicts that the shortterm interest rate can be manipulated to smooth real GDP growth. Short-term interest rates are ‘smooth’ at high frequencies, but display large cycles that appear to be exacerbated since 1987. Equilibria with Taylor rules display such behavior. However the actual cycle in the fed funds rate was even more pronounced than it would have been had the Fed followed Taylor’s famous rule. This paper begins with the working hypothesis that the Fed can control output and perhaps has stabilized output growth. We then ask what such equilibria imply for the cyclical behavior of bank lending and borrower default. The main goal of this paper is to integrate a model of bank lending with default risk into a general equilibrium model of monetary policy. Jimenez et al. (2007) use a large data set on bank loans going back to 1980 to show debt issued when interest rates are low is more likely to default than debt issued when interest rates are high. When the interest rate is held low for a long period, the portfolio of debt in the economy becomes very risky. Financial economists, using partial equilibrium models, have shown that this result is a natural consequence of asymmetric information. Many have argued heuristically that this financial market model has important implications for monetary policy, but no one has integrated the finance theory with the general equilibrium theory that explains how a central bank should implement monetary policy with an interest rate rule. We also want to understand why households (investors) seem ever more willing to take on risky debt when interest rates remain low for long periods. The intuition for this project comes from the nature of equilibria in New Keynesian models when the policymaker is constrained to follow simple rules of thumb in the face of information problems. In the optimal policy rule with full information, the interest rate is actually quite smooth and output follows the optimal path implied by a flexible price model. However, the central bank does not observe this path and actually targets a gap between actual output and a crude trend that is most likely smoother than the optimal path implied by a flexible price model. The result of these simple ‘Taylor’ rules is that the riskless rate tends to deviate from the ‘natural’ rate that is consistent with price stability and the optimal allocation of funds to risky projects. Attempts to reduce the amplitude of output below the size implied by a flexible price RBC model have caused the riskless real rate to fluctuate above the natural rate in and following expansions and below the natural rate in and following recessions. Ultimately, we would want to understand the cycle in the market for risk bearing services. What part of the cycle is due to normal economic forces operating in an efficient economy and what part is due to recent developments in the science of monetary policy? Articles cited: Taylor, John B. “Monetary Policy and the Long Boom,” Federal Reserve Bank of St. Louis Review, November December 1998, 3-11. Jimenez, Gabriel, Steven Ongena, Jose Luis Peydro, and Jesus Saurina, “Hazardous Time for Monetary Policy: What do Twenty-Three Million Bank Loans Say About the Effects of Monetary Policy on Credit Risk? ECB Working Paper 2007-75, September 2007. 2