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Liquidity risk, economic development, and the effects of monetary policy

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  • Ghossoub, Edgar
  • Reed III, Robert R.

Abstract

Empirical evidence indicates that monetary policy is not super-neutral in many countries. In particular, in high inflation economies, inflation is negatively related to economic activity. By comparison, inflation may be positively correlated with output in low inflation countries. We present a neoclassical growth model with money in which the incidence of liquidity risk is inversely related to aggregate capital formation. Interestingly, there may be multiple monetary steady-states where the effects of monetary policy vary. In poor economies, the financial system is highly distorted and higher rates of money growth are associated with less capital formation. In contrast, in advanced economies, a Tobin effect is observed. Since inflation exacerbates distortions from a coordination failure in the low-capital steady-state, individuals become much more exposed to liquidity risk. Consequently, optimal monetary policy depends on the level of development.

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Bibliographic Info

Article provided by Elsevier in its journal European Economic Review.

Volume (Year): 54 (2010)
Issue (Month): 2 (February)
Pages: 252-268

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Handle: RePEc:eee:eecrev:v:54:y:2010:i:2:p:252-268

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Keywords: Economic development Banks Monetary policy;

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Cited by:
  1. Reed, Robert R. & Ghossoub, Edgar A., 2012. "The effects of monetary policy at different stages of economic development," Economics Letters, Elsevier, vol. 117(1), pages 138-141.
  2. Ghossoub, Edgar A., 2012. "Liquidity risk and financial competition: Implications for asset prices and monetary policy," European Economic Review, Elsevier, vol. 56(2), pages 155-173.

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