February 16, 2011 12:00 PM - 1:30 PM
The New Keynesian literature has provided useful intuition regarding macroeconomic relationships and monetary policy. However, standard models lack an explicit financial sector and cannot address questions about the credit channel of monetary policy. This paper adds a financial sector to a canonical New Keynesian model and examines the impact and observability of the credit channel. Microfoundations for the financial sector are based on capital structure and contingent claims pricing theories from finance. The closed form solution sheds light on how the credit channel contributes to monetary policy and why some of its effects are observable while others are not.