The implied consumer Euler rate : what role for financial frictions?

There is increasingly dissatisfaction with the traditional New Keynesian IS curve linking the interest rate to consumption. The central bank'™s interest rate target is found to differ significantly from the implied consumer Euler rate thus impairing the working of the (traditional) monetary transmission mechanism. We look for other determinants of the IS curve that help overcoming its weakness in matching aggregate data. We find a non-negligible role for financial frictions in general, and for the external finance premium in particular, analyzing US data for the Greenspan period. This supports the recent view (see Curdia and Woodford (2010)) that calls central banks to target credit spreads.