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The authors consider a simple extension of the basic new-Keynesian setup in which they relax the assumption of frictionless financial markets. In their economy, asymmetric information and default risk lead banks to optimally charge a lending rate above the risk-free rate. The contribution is threefold. First, they derive analytically the loglinearised equations which characterise aggregate dynamics in the model and show that they nest those of the new-Keynesian model. Second, they find that financial market imperfections imply that exogenous disturbances, including technology shocks, generate a trade-off between output and inflation stabilisation. Third, they show that, in the model, an aggressive easing of policy is optimal in response to adverse financial market shocks.
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