The financial accelerator, wages, and optimal monetary policy

I study the effects of labor market outcomes on firms' loan demand and credit intermediation. I first show in partial equilibrium that the presence of frictions in the banking sector lowers the capital factor demand elasticity to changes in real wages. This finding helps to connect the substitutability of labor and capital with credit conditions. Second, I use a new Keynesian banking model with an endogenous financial accelerator mechanism to study the role of lower capital factor demand elasticity in the transmission mechanism of monetary policy. Stabilizing nominal wages is close to the optimal monetary policy because it coincides with stabilizing the credit spread, the net worth gap, and the output gap. Inflation stabilization, in turn, imposes a policy trade-off with high welfare costs. • The presence of frictions in the banking sector lowers the capital factor demand elasticity to changes in real wages. • The higher bankers' net worth the less sensitive is the capital demand to changes in real wages. • Wage inflation targeting stabilizes the output gap, credit spread, and the net worth gap of bankers. • Inflation targeting imposes a policy trade-off between inflation stabilization and wage inflation stabilization.