Let us now analyze how the macroeconomic friction affects our model economy. As it is wellknown from the standard New Keynesian literature, there are two potential distortions in modelswith monopolistic competition and staggered pricing. First, monopolistic power forces averageoutput below the socially optimal level. Second, staggered pricing implies that both the econ-omy’s average markup and the relative price of different goods will vary over timein responseto shocks, violating efficiency conditions.12As we shall see below, our model displays a similarbehavior.Let us assume for the moment that interest rates can freely adjust and that lending rates at the be-ginning of period 0 are set at the desired level, as a markup over the marginal cost (RL1=MR).If a positive shocku>0 hits the economy, banks face a new, higher marginal cost and updatetheir lending interest rates such thatRL1=M(R+u). Households update their loans demandaccordingly and the loans market clears at a higher lending rate. In response to the higher interestrate, consumption and borrowing in period 0 fall relative to the case in whichu=0. This alloca-tion (henceforth “flex-rates” allocation) is efficient, conditional on the shocku.