Optimal Monetary Policy with Sticky Nominal Debt Contracts

In this paper, in contrast to the standard "Optimising IS-LM" framework, the monetary policy problem arises from within the model. I consider the impact on the monetary policy transmission mechanism, and on the objectives of policy itself, when some consumers are subject to credit constraints, and debt contracts are sticky in nominal terms. The consumption of this group will respond both to fluctuations in output, and in the nominal interest rate. Monetary policy can be seen as a mechanism to achieve a more socially desirable outcome by redistributing consumption variance between constrained and unconstrained consumers. Assuming some positive weight is given to the welfare of both groups, a number of general features of optimal monetary policy can be derived. Most notably, that the real interest rate should optimally fall in the face of inflation shocks; and that the impact of demand shocks on output should never be fully eliminated.