Optimal Monetary Policy Rules, Financial Amplification, and Uncertain Business Cycles

This paper studies whether financial variables per se should matter for monetary policy. Earlier consensus view - using financial amplification models with disturbances that have no direct effect on credit market conditions- suggests that financial variables should not be assigned an independent role in policy making. Introducing uncertainty, time- variation in cross-sectional dispersion of firms� productive performance, alters this policy prescription. The results show that (i) optimal policy is to dampen the strength of financial amplification by responding to uncertainty (at the expense of creating a mild degree of fluctuations in inflation). Moreover, a higher uncertainty makes the planner more willing to relax the financial constraints. (ii) Credit spreads are a good proxy for uncertainty, and hence, within the class of simple monetary policy rules I consider, a non-negligible response to credit spreads -together with a strong anti-inflationary stance- achieves the highest aggregate welfare possible.