Optimal Monetary Policy in a Channel System∗

This paper studies monetary policy when the central bank operates a channel system of interest control. We conduct our analyses in a dynamic general equilibrium model with infinitely-lived agents where money is essential for trade. We characterize the equilibrium allocation and optimal policy under two assumptions: when the central bank has the ability to force repayment of loans and when central bank credit is subject to a default constraint. Under both assumption, it is optimal to set the deposit and lending rates equal. Under the first assumption, we find that the Friedman rule holds, i.e., it is optimal to set a nominal interest rate of zero. When credit is subject to a default constraint, however, it is optimal to choose a strictly positive interest rate, implying that the Friedman rule is not optimal. ∗We have received useful comments from the participants of several seminars and workshops. We are especially grateful to Christopher Waller for his comments. Berentsen thanks the Federal Reserve Bank of Cleveland and European Central Bank for research support. The views expressed herein are those of the authors and not those of the European Central Bank or the Eurosystem.