Optimal Monetary Policy with Counter-Cyclical Credit Spreads

We study optimal monetary policy in a New Keynesian-DSGE model where the combination of a credit channel and customer-market features in banking gives rise to counter-cyclical credit spreads. In our setting, monopolistically competitive banks set lending rates in a forward-looking fashion as they internalize the fact that, due to borrowers. bank-specific (hence deep) habits, current interest rates also affect the future demand for loans by financially constrained. In particular, during a phase of economic expansion, banks might find it optimal to lower current lending rates to build up a larger customer base, which will be locked into a long-term relationship. The resulting counter-cyclicality of credit spreads makes optimal monetary policy depart substantially from the efficient allocation (and hence from price stability), under both discretion and commitment. Our analysis shows that the welfare costs of setting monetary policy under discretion (with respect to the optimal Ramsey plan) and of using simpler sub-optimal policy rules are strictly increasing in the magnitude of deep habits in credit markets and market power in banking.