Credit frictions and optimal monetary policy

We extend the basic (representative-household) New Keynesian [NK] model ofthe monetary transmission mechanism to allow for a spread between the interestrate available to savers and borrowers, that can vary for either exogenous orendogenous reasons. We nd that the mere existence of a positive average spreadmakes little quantitative difference for the predicted effects of particular policies.Variation in spreads over time is of greater signicance, with consequences both forthe equilibrium relation between the policy rate and aggregate expenditure and forthe relation between real activity and ination.Nonetheless, we nd that the target criterion a linear relation that shouldbe maintained between the ination rate and changes in the output gap thatcharacterises optimal policy in the basic NK model continues to provide a goodapproximation to optimal policy, even in the presence of variations in credit spreads.We also consider a spread-adjusted Taylor rule, in which the intercept of the Taylorrule is adjusted in proportion to changes in credit spreads...