Business cycle and monetary policy analysis with market rigidities and financial frictions

Abstract

We describe a dynamic macroeconomic model that incorporates firm-level borrowing constraints, competitive CES loan production, and rigidities on both setting prices and wages. The external finance premium (interest-rate spread) is countercyclical with technology and financial shocks, and procyclical with consumption spending shocks. The real effects of financial shocks are significantly amplified when either considering greater rigidities for price/wage setting or a low elasticity of substitution in loan production (banking real rigidities). In the monetary policy analysis, a stabilizing Taylor (1983)-style rule performs slightly better when incorporating a positive and small response coefficient to the external finance premium.