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Article Excerpt
Summary. We consider a sticky-price model with segmented asset markets, and examine its implications for monetary policy. Our finding is, first, that the response of the money supply growth rate to a money demand shock required to stabilize inflation is not affected by the existence of a liquidity effect, but the response of the nominal interest rate is. Second, when the monetary authority adopts a Taylor rule, whether or not it should be active to obtain local determinacy of equilibria depends on the existence of a liquidity effect. Our results suggest that the monetary authority should be careful about the existence and the degree of a liquidity effect particularly when the nominal interest rate is used as the policy instrument.
Keywords and Phrases: Monetary policy, Sticky prices, Segmented markets, Liquidity effect, Taylor rule.
JEL Classification Numbers: E3, E4, E5.
1 Introduction
There is strong evidence that there is a long-run positive relationship between money supply growth rates and nominal interest rates (e.g., Monnet and Weber, 2001). Such a relationship is explained as the Fisherian effect: given the real interest rate, the nominal interest rate increases with the expected inflation rate. A higher money growth rate increases the inflation rate in the future, and thus, the nominal interest rate. In the short run, however, the relationship between money growth rates and nominal interest rates is much less clear. Indeed, the nominal interest rate and money growth rate may move in opposite directions in the short run (the liquidity effect). As is well known, the standard, complete-markets model without asset-market imperfections cannot generate the liquidity effect. To account for such an effect, we need some frictions in the asset market. A class of models which are consistent with the liquidity effect are those with asset market segmentation. (1) In such a model a liquidity effect arises because, when the monetary authority injects money through open market operations, money injections are absorbed exclusively by only a subset of agents, which increase their consumption and thus reduce the real interest rate.
The existence of a liquidity effect can have an important consequence on how the monetary authority should react to a disturbance to the economy. For example, Alvarez et al. (2001) consider a simple segmented-market economy, in which a fraction of agents are assumed not to participate in the asset market, and compare different monetary policy rules with respect to inflation stabilization. In their model, aggregate output is given exogenously, however. In this paper, we introduce nominal rigidities (sticky prices) in their model so that output also fluctuates in response to monetary policy as well as exogenous disturbances. (2)
Following Alvarez et al. (2001), we consider an economy in which only a subset of households actively trade financial assets in the asset market. Specifically, we assume that households are of two types: workers and capitalists. Workers supply labor to firms, receive labor income in cash, and have no access to the asset market. Capitalists, on the other hand, own firms, receive dividends in cash, and trade cash and contingent claims in the asset market. Thus, the asset market is segmented. The production side of the economy is similar to the model of Woodford (2003, Chapter 3). There is a continuum of differentiated products, each of which is produced by a monopolistic firm. The price of each product is adjusted stochastically as in Calvo (1983).
We compare implications for monetary policy between our model and the standard sticky-price model without market segmentation. First, we ask how monetary policy should respond to a velocity shock (i.e., money demand shock) to stabilize inflation. (3) We show that, as long as the money growth rate is the instrument of monetary policy, there is no significant difference between the models with and without market segmentation: money supply should change by the amount that is enough to offset the change in money demand. If the policy target is the nominal interest rate, however, the existence of segmented markets affects how to respond to a money demand shock. Without market segmentation, as is well known, the nominal interest rate should be kept constant to offset the effect of a money demand shock. With market segmentation, however, should actively respond to such a shock.
Second, we consider the monetary policy rule known as the Taylor rule, that specifies the nominal interest rate as an increasing function of the inflation rate. As is discussed in Woodford (2003), the standard sticky-price model implies that the Taylor rule should be "active" to obtain local determinacy of equilibrium; that is, the nominal interest rate should be raised more than proportionately when the...
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