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Liquidity Effects and Market Frictions

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  • Hendry, Scott
  • Zhang, Guang-Jia

Abstract

The goal of this paper is to shed light on the nature of the monetary transmission mechanism. Specifically, we attempt to tackle two problems in standard limited-participation models: (1) the interest rate liquidity effect is not as persistent as in the data; and (2) some nominal variables are unrealistically volatile. To address these problems, we introduce nominal wage and price rigidities, as well as portfolio adjustment costs and monopolistically competitive firms, to better understand how each of these costs affects the size and length of the liquidity effect following a central-bank policy action. Quantitative analysis shows that including these rigidities does improve the model, to some extent at least, in the expected manner. The main findings are: (1) wage and portfolio adjustment costs are able to deepen and lengthen the liquidity effect following a monetary policy action; (2) these two adjustment costs, especially wage adjustment costs, can reduce inflation volatility; (3) price adjustment costs, at least under money-growth policy rules, cause excessive interest-rate volatility and are unable to significantly reduce inflation volatility.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Macroeconomics.

Volume (Year): 23 (2001)
Issue (Month): 2 (April)
Pages: 153-176

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Handle: RePEc:eee:jmacro:v:23:y:2001:i:2:p:153-176

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Web page: http://www.elsevier.com/locate/inca/622617

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References

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  1. V. V. Chari & Patrick J. Kehoe & Ellen R. McGrattan, 1998. "Sticky price models of the business cycle: can the contract multiplier solve the persistence problem?," Staff Report 217, Federal Reserve Bank of Minneapolis.
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Citations

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Cited by:
  1. Peter Ireland & Niki Papadopoulou, 2004. "Sticky Prices vs. Limited Participation: What Do We Learn From the Data?," Money Macro and Finance (MMF) Research Group Conference 2004 79, Money Macro and Finance Research Group.
  2. Stracca, Livio, 2001. "Does liquidity matter? Properties of a synthetic divisia monetary aggregate in the euro area," Working Paper Series 0079, European Central Bank.
  3. Niki X. Papadopoulou, 2008. "Sticky Prices, Limited Participation, or Both?," Working Papers 2008-4, Central Bank of Cyprus.
  4. Shamik Dhar & Stephen P Millard, 2000. "How well does a limited participation model of the monetary transmission mechanism match UK data?," Bank of England working papers 118, Bank of England.
  5. Hendry, S. & Zhang, G., 1998. "Liquidity Effects and Market Frictions," Working Papers 98-11, Bank of Canada.
  6. Chung, Kyuil, 2009. "Does the liquidity effect guarantee a positive term premium?," Economic Modelling, Elsevier, vol. 26(5), pages 893-903, September.
  7. Laidler, David, 1999. "The Quantity of Money and Monetary Policy," Working Papers 99-5, Bank of Canada.
  8. Dib, Ali, 2006. "Nominal rigidities and monetary policy in Canada," Journal of Macroeconomics, Elsevier, vol. 28(2), pages 303-325, June.
  9. Shamik Dhar & Stephen P Millard, 2000. "A limited participation model of the monetary transmission mechanism in the United Kingdom," Bank of England working papers 117, Bank of England.
  10. Frédéric Karamé & Lise Patureau & Thepthida Sopraseuth, 2003. "Limited participation and exchange rate dynamics : does theory meet the data ?," Cahiers de la Maison des Sciences Economiques v04013, Université Panthéon-Sorbonne (Paris 1).
  11. Niki Papadopoulou, 2006. "Sticky Prices vs. Limited Participation:What Do We Learn From the Data?," Computing in Economics and Finance 2006 418, Society for Computational Economics.
  12. Patureau, Lise, 2007. "Pricing-to-market, limited participation and exchange rate dynamics," Journal of Economic Dynamics and Control, Elsevier, vol. 31(10), pages 3281-3320, October.

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