Optimal monetary policy with capital and a financial accelerator

Whether there is a trade-off between price and financial stability is an open question. This paper characterises optimal monetary policy analytically in a New Keynesian economy with capital and a financial accelerator. In addition to stabilising inflation, there is an incentive to smooth volatility in the net worth of borrowers and this presents a trade-off for monetary policy. This trade-off can be eliminated if policymakers can additionally choose an optimal transfer to borrowers. Enriching the model with fire sales and countercyclical bankruptcy costs, there is also an incentive to smooth volatility in default and the capital stock. An optimal transfer to borrowers is not sufficient to eliminate the trade-off in that case. With fewer instruments than targets, optimal transfers are state contingent and countercyclical, while monetary policy stabilises inflation.