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LIQUIDITY SHOCKS, EQUITY-MARKET FRICTIONS, AND OPTIMAL POLICY

Published online by Cambridge University Press:  26 February 2014

Harris Dellas ,
Behzad Diba  and
Olivier Loisel
Harris Dellas
Affiliation:
University of Bern
Behzad Diba
Affiliation:
Georgetown University
Olivier Loisel*
Affiliation:
CREST (ENSAE)
*
Address correspondence to: Olivier Loisel, ENSAE, Timbre J120, 3 Avenue Pierre Larousse, 92245 Malakoff Cédex, France; e-mail: olivier.loisel@ensae.fr; URL: http://www.cepremap.fr/membres/olivier.loisel.
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Abstract

In this paper, we study the positive and normative implications of financial shocks in a standard New Keynesian model that includes banks and frictions in the market for bank capital. We show how such frictions influence materially the effects of bank liquidity shocks and the properties of optimal policy. In particular, they limit the scope for countercyclical monetary policy in the face of these shocks. A fiscal policy instrument can complement monetary policy by offsetting the balance-sheet effects of these shocks, and jointly optimal policies attain the same equilibrium that monetary policy (alone) could attain in the absence of equity-market frictions.

Keywords

Financial ShocksRamsey Optimal Monetary and Fiscal PolicyBanks
Type
Articles
Information
Macroeconomic Dynamics , Volume 19 , Special Issue 6: Growth, Optimal Fiscal and Monetary Policy, and Financial Frictions , September 2015 , pp. 1195 - 1219
Copyright
Copyright © Cambridge University Press 2014 

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