Optimal monetary policy rules, financial amplification, and uncertain business cycles

This paper studies how monetary policy should be conducted when the economy is driven not only by first-moment shocks typically studied in the literature (like productivity or government spending shocks) but also by second-moment -`uncertainty'- shocks (an exogenous change in cross-sectional dispersion of firms' productivity). Using a standard New-Keynesian model with financial frictions (a la` Bernanke, Gertler, and Gilchrist, 1999), the results suggest that time-variation in cross-sectional dispersion exacerbates credit frictions in the economy and leads to inefficient fluctuations. To mitigate such inefficiencies, it is optimal to respond to credit spreads in a simple monetary policy rule. Under `higher uncertainty' (for which credit spreads fluctuate stronger), the optimal degree of policy response to the spreads rises.