Output Gap, Monetary Policy Trade-offs, and Financial Frictions

This paper investigates how the presence of pervasive financial frictions and large financial shocks changes the optimal monetary policy prescriptions and the estimated dynamics in a New Keynesian model. We find that financial factors affect the optimal policy only to some extent. A policy of nominal stabilization (with a particular focus on targeting wage inflation) is still the optimal policy, although the central bank is now unable to fully stabilize economic activity around its potential level. In contrast, the presence of financial frictions and financial shocks crucially changes the size and shape of the estimated output gap and the relative importance of different shocks in driving economic fluctuations, with financial shocks absorbing explanatory power from labor supply shocks.