This paper develops a computable general equilibrium model in which endogenous agency costs can potentially alter business cycle dynamics. The model resembles the influential theoretical work of Bemanke and Gertler ( 1989), from whom we borrow our title. The model is calibrated to match key features of U.S. aggregate activity. Two sources of shocks are considered: shocks to the distribution of wealth and shocks to aggregate productivity. We reach two conclusions. First, "debt-deflations" can have a significant and persistent effect on real activity. In the case of large monitoring costs, a relatively small wealth redistribution (corresponding to a one-time annual surprise inflation of 1.0 percent) leads to a 0.5 percent increase in investment spending. Second, the agency-cost model naturally delivers a hump-shaped investment response to a productivity shock. This is because households delay their investment decisions until agency costs are at their lowest, a point in time several periods after the initial shock.

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This paper integrates a fully explicit model of agency costs into an otherwise standard Dynamic New Keynesian (DNK) model in a particularly transparent way. A principle result is the characterization of agency costs as endogenous mark-up shocks in an output-gap version of the Phillips curve. The model's utility-based welfare criterion is derived explicitly and includes a measure of credit market tightness which we interpret as a risk premium. The paper also fully characterizes optimal monetary policy and provides conditions under which zero inflation is the optimal policy. Finally, optimal policy can be expressed as an inflation targeting criterion that (depending upon parameter values) can be either forward or backward-looking.

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