Indebted Supply and Monetary Policy: A Theory of Financial Dominance

We develop a New Keynesian model with financial frictions to study how corporate capital structure shapes static and dynamic monetary policy tradeoffs through the supply side. Ex post, when corporate leverage is high, monetary tightening contracts both demand and supply. As a result, the Phillips curve is highly non-linear and state-dependent, and the “natural rate” Rⁿ ensuring price stability increases with corporate leverage. Yet the tradeoff between inflation targeting and tightening supply constraints implies that the optimal ex-post policy is to set a rate Rᵒᵖᵗ < Rⁿ that can decrease with leverage. Ex ante, firms’ market-timing incentives lead them to increase leverage when rates are low, which creates an intertemporal tradeoff: monetary easing supports current demand but hurts future supply, which makes easing partially self-defeating. The optimal ex-ante monetary policy features a prudential motive for leaning against leverage even when the divine coincidence holds in the current period.