SMU SOE Seminar Series (November 11, 2026): Credit Market Incompleteness and the Inflation Target - Rate Policy Mix

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ABSTRACT

In a neoclassical growth model, I identify a source of price level drifts to be the market incompleteness preventing firms from hiring factors on households’ credit, while uncovering a condition for an inflation target to be optimal. Specifically, I find that (i) when firms cannot hire factors on credit from their owners —nor borrow from financial intermediaries for that— prices need to be stable at a steady state, while inflation is indeterminate with financial intermediaries, making financialization a necessary condition for sustained inflation in the model; (ii) there is a steady state positive relation between banks’ money creation and inflation, and (iii) financial intermediation partially improves the steady state efficiency, but restores full efficiency only for specific combinations of inflation targets and lending rates, given firms’ leverage and discounting. Then, the characterizations of the first-best steady state and market steady state with financial intermediaries show that the former can be sustained by any inflation target, provided the adequate lending rate, calling into question the choice of 2% —by the Fed and the ECB among others— as the right target. Although 2% can be optimal for specific lending rates (depending on firms’ leverage bounds and discounting), so can other targets for the adequate rates. Lending rates turning 2% optimal run, in the model, from 0.68% to 3.06%, for a firms’ leverage of their period output of 1.2 to 4.0 times its value, at a discounting δf = .98, with an upper limit —as the leverage bound increases unboundedly— of 4.08% for the given discounting. These values are shown to depend robustly on discounting and leverage conditions. Finally, the lending rate turning an inflation target optimal increases affinely with the latter —as does its upper bound for an unlimited leverage— at a rate depending on the firms’ leverage.

Keywords: Optimal Inflation Target, Credit Market Incompleteness, Rates Policy, Firm Leverage.

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