Role of financial systems in a sticky price model

This paper studies the role of financial institutions in a sticky price model. It focuses on the role of lending rate smoothing associated with bank-based financial systems. Our model shows that introducing partial lending rate smoothing can generate a positive, sluggish inflation response after monetary tightening. In particular, when the relative risk aversion takes a slightly higher value, moderate lending rate smoothing helps explain the empirical fact that previous studies of monetary transmission observe a positive, hump-shaped inflation response to a monetary contraction. In contrast to previous studies, which argue that policy rate smoothing prevents the price puzzle, our results show that the price puzzle is likely to occur when the relative risk aversion takes a higher value, even if the central bank employs a higher weight on the term for the lagged policy rate in its monetary policy rule.