Optimal Monetary Policy in a Model with Agency Costs


  • We would like to thank Tommaso Monacelli, Simon Gilchrist, Tony Yates, Jens Sondergaard, two anonymous referees, and the editors for comments on an earlier draft of this paper. The work reported in this paper was substantially carried out when Matthias Paustian was affiliated solely with Bowling Green State University. The views expressed in this paper are those of the authors and not necessarily those of the Bank of England, the Federal Reserve Bank of Cleveland, or of the Board of Governors of the Federal Reserve System or its staff.


This paper integrates a fully explicit model of agency costs into an otherwise standard Dynamic New Keynesian model in a particularly transparent way. A principal result is the characterization of agency costs as endogenous markup shocks in an output-gap version of the Phillips curve. The model's utility-based welfare criterion is derived explicitly and includes a measure of credit market tightness that we interpret as a risk premium. The paper also fully characterizes optimal monetary policy and provides conditions under which zero inflation is the optimal policy. Finally, optimal policy can be expressed as an inflation targeting criterion that (depending upon parameter values) can be either forward or backward looking.