Fixed versus Variable Rate Debt Contracts and Optimal Monetary Policy

What role does the proportion of fixed versus variable rate debt contracts play in the macroeconomy? We explore this issue by integrating borrowing-constrained households with a quantity-optimising banking sector that lends under either fixed or variable rates. Our framework is then used to investigate the relationships between the structure of debt contracts and monetary policy. In particular, we study the propagation of productivity shocks in the non-durable sector under Ramsey monetary policy. The introduction of overlapping debt contracts tempers the effect of the financial multiplier and reduces the deterministic component of social welfare, but we also show that an appropriate design of debt contracts, including both their length and their interest rate composition, can reduce volatility of the key economic variables, in such a way that the financial sector can play a stabilising role in the economy. We demonstrate that an intermediate ratio of fixed- and variable-rate debt contracts is socially optimal.