Credit Market Imperfections and the Monetary Transmission Mechanism Part II: Flexible Exchange Rates

Monetary policy is analyzed in a simple model with credit market imperfections, flexible prices, and a floating exchange rate. Banks’ lending rates incorporate a premium, which depends on firms’ net worth, over the cost of borrowing from the central bank. In contrast to models in the Kiyotaki-Moore tradition, the supply of bank loans is perfectly elastic at the prevailing lending rate. The central bank sets the refinance rate and provides banks with unlimited access to liquidity at that rate. The model is used to study the macroeconomic effects of changes in the refinance and reserve requirement rates, central bank auctions, shifts in the risk premium and contract enforcement costs, and changes in public spending and world interest rates.