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We study a simple extension of the basic new-Keynesian set-up in which we relax the assumption of frictionless financial markets: due to asymmetric information and default risk, bank lending rates incorporate a spread over the deposit rate. We demonstrate that financial frictions affect aggregate dynamics mainly through their impact on firms’ financing costs, which increase in both the deposit rate and in the spread between lending and deposit rates. Welfare includes a concern for smoothing these two financial market variables. Our numerical simulations suggest that an aggressive easing of policy is optimal in response to adverse financial market shocks.