Can Financial Frictions Help Explain the Performance of the US Fed?

This paper investigates whether the presence of financial frictions can help explain the differences in the variability of output and inflation between the Pre- and the Post-Volcker periods. I use a limited participation model with credit market imperfections, in which financial frictions may alter the stabilization effects of monetary policy, as shown in a previous paper of mine. In this setup, I study the interest rate rule followed by the Federal Reserve Bank in the last 40 years considering the presence of credit market imperfections and allowing for a breakpoint in the monetary policy rule, the degree of financial frictions and shock processes. An interest rate rule is estimated for each of the two identified sub-samples. In the absence of financial frictions, the results confirm the widely recognized change in the conduct of monetary policy by reporting substantially different interest rate rules before and after 1981:2, but fail to assign more weight to inflation stabilization in the second sub-sample. Interestingly, with positive monitoring costs the two calibrated rules are much less different, that is, a far smaller change in policy suffices for stabilization when imperfect credit markets are considered. This may suggest a key role for credit market imperfections in the stabilization effects of monetary policy. When the rule, shocks and monitoring costs are allowed to adjust between sub-samples, the calibration reports interest rate rules that assign more weight to inflation and less to output stabilization after 1981:2. Money demand processes vary between sub-samples, whereas technology innovations remain relatively stable across time, which is consistent with standard literature