Monetary and Macroprudential Policy with the Cost Channel and Credit Market Imperfections

  • Chashika Kalubowila

Student thesis: Phd


The consequences of the Great Recession have led to a major rethink in economics, which identifies the importance of the financial sector in macroeconomic developments. It is now widely accepted that financial frictions play a major role in amplifying and propagating the effect of a shock and have a much greater impact on the real economy. The mainstream literature however, has not given much attention to the implications of financial frictions transmitted through the cost channel. This is because most cost channel literature follows the credit channel framework of Bernanke and Gertler (1989) to model the financial frictions and assumes working capital is borrowed at a risk-free rate. Therefore, in these studies, the effect of financial frictions is transmitted mainly through the standard demand-side channels, similar to standard New Keynesian models and does not have any supply-side effect. This thesis is an attempt to contribute to this strand of literature by identifying the role of credit market imperfections in the presence of a cost channel. Counter-cyclical finance premium is a necessary condition to explain the amplification effect of the finance premium in theoretical cost channel models. Yet, some cost channel models have reached opposing theoretical conclusions about the cyclicality of the finance premium. In Chapter 2, we study how the degree of stickiness in factor prices might affect the cyclicality of the finance premium that arise as a result of information asymmetry and endogenous defaults in the presence of a cost channel. Our results show that, following a monetary policy shock, when either of the factor prices—wages or capital rental rate—are sufficiently flexible, the finance premium becomes pro-cyclical. If both factor prices are sufficiently sticky, then we observe a counter-cyclical finance premium. However, we observe a counter-cyclical finance premium for a productivity shock, regardless of the degree of stickiness in factor prices. Therefore, in Chapter 2, we conclude that the degree of stickiness in factor prices is one of the contributing factors in determining the cyclicality of the finance premium in a cost channel model, under monetary policy shocks, but not under productivity shocks. This partly explains the reasons for the opposing theoretical conclusions we observe among some of the theoretical cost channel models. Airaudo and Olivero (2019) have identified that the single instrument (monetary policy only) Ramsey optimal policy leads to a short-run policy trade-off between stabilising inflation and the output in the presence of a cost channel. They further explain that the presence of a counter-cyclical finance premium exacerbates this policy trade-off. In Chapter 3, we attempt to study how the Ramsey optimal mix of monetary and macroprudential policy (Ramsey coordination policy) might contribute to mitigating this policy trade-off in the presence of a cost channel. Our results show that Ramsey coordination policy can fully eliminate the short-run policy trade-off that arises due to the presence of deep habits in banking and can achieve full stabilisation in both inflation and output. In contrast, our results further show that full stabilisation cannot be achieved in the presence of endogenous defaults, even if the social planner adopts the Ramsey coordination policy. Therefore, these results conclude that, in a theoretical cost channel model, the ability of the Ramsey coordination policy to fully stabilise inflation and the output depends on the source of the credit market friction. A further key result in Chapter 3 is that adopting an unconstrained simple optimal monetary and macroprudential coordination rule would come very close to the performance of a Ramsey optimal rule in terms of household welfare and the stabilisation of inflation and output.
Date of Award1 Aug 2023
Original languageEnglish
Awarding Institution
  • The University of Manchester
SupervisorGeorge Bratsiotis (Supervisor) & Michele Berardi (Supervisor)


  • Deep Habits in Banking
  • Welfare
  • Default
  • Finance Premium
  • OSR
  • Ramsey Policy
  • Optimal Policies
  • Cost Channel
  • Macroprudential Policy
  • Monetary Policy
  • DSGE
  • Credit Market

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