Financial Shocks and Optimal Policy

In this paper, we study the positive and normative implications of financial shocks in a standard New Keynesian model that includes banks and frictions in the market for bank capital. We show how such frictions influence materially the effects of liquidity shocks and the properties of optimal policy. In particular, they limit the scope for countercyclical monetary policy in the face of bank liquidity shocks and induce large adjustments in the money supply (a property reminiscent of Poole’s analysis). They also call for a fiscal policy that complements monetary policy by offsetting the balance-sheet effects of liquidity shocks. ∗We want to thank Fabrice Collard, Luisa Lambertini, Nobu Kiyotaki and Patrick Pintus for valuable suggestions.