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Working Paper

Leverage, Investment, and Optimal Monetary Policy

We study optimal monetary policy in an economy where the debt overhang of firms leads to underinvestment and underproduction. The magnitude of this debt-induced distortion varies over the business cycle, rising significantly during recessions. When debt is contracted in nominal terms, this distortion gives rise to a balance sheet channel for monetary policy. In the presence of real and financial shocks, the monetary authority faces a trade-off between inflation and output gap stabilization. The optimal monetary policy rule prescribes that the anticipated component of inflation should be set equal to a target level, while the unanticipated component should rise in response to adverse shocks, smoothing the debt overhang distortion and the output gap.

Working Papers of the Federal Reserve Bank of Cleveland are preliminary materials circulated to stimulate discussion and critical comment on research in progress. They may not have been subject to the formal editorial review accorded official Federal Reserve Bank of Cleveland publications. The views expressed in this paper are those of the authors and do not represent the views of the Federal Reserve Bank of Cleveland or the Federal Reserve System.


Suggested Citation

Occhino, Filippo, and Andrea Pescatori. 2012. “Leverage, Investment, and Optimal Monetary Policy.” Federal Reserve Bank of Cleveland, Working Paper No. 12-38. https://doi.org/10.26509/frbc-wp-201238