Optimal Simple Objectives for Monetary Policy when Banks Matter

IMF Working Papers, November 13, 2020

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Reconsiders welfare-optimal monetary policy design when financing frictions impair the supply of bank credit and when policy objectives must be simple and implementable.
A flexible inflation targeting rule that places weight on:
- stabilizing inflation,
- a measure of resource utilization, and
- a financial variable

produces welfare benefits that are almost indistinguishable from fully-optimal Ramsey policy.

In the authors’ estimated model of the euro area, the macro-financial trade-off is modest, implying that the effects of financial frictions can be ameliorated at little cost in terms of inflation.
A range of different financial objectives and policy preferences lead to similar conclusions.

Focus: interaction of monetary policy and banks under financing frictions affecting bank credit supply.
Geographic/econometric scope: estimated model of the euro area.
Subject classifications listed on the page:
- Economic theory
- Financial frictions
- Inflation
- Inflation targeting
- Monetary policy
- Output gap
- Prices
- Production
- Production growth
Keywords provided on the page include: Banks, Euro area economy, Financial frictions, Inflation, Inflation targeting, inflation-output gap trade-off, Medium-scale DSGE models, Monetary policy, Output gap, output gap stabilization, output gap volatility, output gap-inflation trade-off, Production growth, Simple loss function, stabilization objective, WP

Simple, implementable objectives that augment standard flexible inflation targeting with a financial variable and a measure of resource utilization can achieve near-Ramsey welfare outcomes.
Policymakers in the euro area context can address financial-frictions-induced distortions with limited inflation cost.
Robustness: similar outcomes arise across different choices of financial objectives and alternative policy preferences, suggesting broad applicability of the simple-objectives approach.

Source: Optimal Simple Objectives for Monetary Policy when Banks Matter (IMF Working Paper No. 2020/244).