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The authors develop a model for monetary policy analysis that features significant feedback from asset prices to macroeconomic quantities. The feedback is caused by credit market imperfections, which dynamically affect how efficiently labor and capital are being used in aggregate. The paper offers three insights. First, the monetary transmission mechanism works not only via nominal rigidities but also via a reallocation of productive resources away from the most productive agents. Second, following an adverse productivity shock there is a dynamic trade-off between the immediate fall in output, which is an efficient response to the productivity fall, and the fall in output thereafter, which is caused by a reallocation of resources away from the most productive agents.
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