Output Gap in Presence of Financial Frictions and Monetary Policy Trade-offs

Author/Editor:

Francesco Furlanetto ; Paolo Gelain ; Marzie Taheri Sanjani

Publication Date:

July 18, 2014

Electronic Access:

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Disclaimer: This Working Paper should not be reported as representing the views of the IMF.The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate

Summary:

The recent global financial crisis illustrates that financial frictions are a significant source of volatility in the economy. This paper investigates monetary policy stabilization in an environment where financial frictions are a relevant source of macroeconomic fluctuation. We derive a measure of output gap that accounts for frictions in financial market. Furthermore we illustrate that, in the presence of financial frictions, a benevolent central bank faces a substantial trade-off between nominal and real stabilization; optimal monetary policy significantly reduces fluctuations in price and wage inflations but fails to alleviate the output gap volatility. This suggests a role for macroprudential policies.

Series:

Working Paper No. 2014/128

Subject:

Economic theory Financial frictions Inflation Labor Output gap Potential output Prices Production Wages

English

Publication Date:

July 18, 2014

ISBN/ISSN:

9781498305327/1018-5941

Stock No:

WPIEA2014128

Pages:

44

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