Bank Capital, Asset Prices and Monetary Policy

46 Pages Posted: 28 Sep 2006

See all articles by David Aikman

David Aikman

Bank of England - Monetary Assessment and Strategy Division

Matthias O. Paustian

Board of Governors of the Federal Reserve System

Date Written: August 2006

Abstract

We study a general equilibrium model in which informational frictions impede entrepreneurs' ability to borrow and banks' ability to intermediate funds. These financial market frictions are embedded in an otherwise-standard dynamic New Keynesian model. We find that exogenous shocks have an amplified and more persistent effect on output and investment, relative to the case of perfect capital markets. The chief contribution of the paper is to analyse how these financial sector imperfections - in particular, those relating to the banking sector - modify our understanding of optimal monetary policy. Our main finding is that optimal monetary policy tolerates only a very small amount of inflation volatility. Given that similar results have been reported for models that abstract from banks, we conclude that assigning a non-trivial role for banks need not materially affect the properties of optimal monetary policy.

Keywords: Banks, moral hazard, credit market frictions, price rigidities, optimal monetary policy

JEL Classification: E44, E32, E52

Suggested Citation

Aikman, David and Paustian, Matthias O., Bank Capital, Asset Prices and Monetary Policy (August 2006). Bank of England Working Paper No. 305, Available at SSRN: https://ssrn.com/abstract=933294 or http://dx.doi.org/10.2139/ssrn.933294

David Aikman (Contact Author)

Bank of England - Monetary Assessment and Strategy Division ( email )

Threadneedle Street
London EC2R 8AH
United Kingdom

Matthias O. Paustian

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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