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Liquidity Effects and Market Frictions

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  • Hendry, S.
  • Zhang, G.

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

Paper provided by Bank of Canada in its series Working Papers with number 98-11.

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Length: 53 pages
Date of creation: 1998
Date of revision:
Handle: RePEc:bca:bocawp:98-11

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Keywords: Transmission of monetary policy;

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References

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  1. Basu, S., 1993. "Intermediate Goods and Business Cycles: Implications for Productivity and Welfare," Papers 93-23, Michigan - Center for Research on Economic & Social Theory.
  2. Michael Dotsey & Peter Ireland, 1994. "Liquidity effects and transactions technologies," Proceedings, Federal Reserve Bank of Cleveland, pages 1441-1471.
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  6. Lawrence J. Christiano & Martin Eichenbaum & Charles L. Evans, 1996. "Sticky price and limited participation models of money: a comparison," Working Paper Series, Macroeconomic Issues WP-96-28, Federal Reserve Bank of Chicago.
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  8. Hendry, S. & Zhang, G., 1998. "Liquidity Effects and Market Frictions," Working Papers 98-11, Bank of Canada.
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Citations

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Cited by:
  1. Chung, Kyuil, 2009. "Does the liquidity effect guarantee a positive term premium?," Economic Modelling, Elsevier, vol. 26(5), pages 893-903, September.
  2. 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.
  3. David Longworth & Brian O’Reilly, 2000. "The Monetary Policy Transmission Mechanism and Policy Rules in Canada," Working Papers Central Bank of Chile 72, Central Bank of Chile.
  4. Niki X. Papadopoulou, 2008. "Sticky Prices, Limited Participation, or Both?," Working Papers 2008-4, Central Bank of Cyprus.
  5. Stracca, Livio, 2001. "Does liquidity matter? Properties of a synthetic divisia monetary aggregate in the euro area," Working Paper Series 0079, European Central Bank.
  6. 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.
  7. Laidler, David, 1999. "The Quantity of Money and Monetary Policy," Working Papers 99-5, Bank of Canada.
  8. 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).
  9. 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.
  10. Dib, Ali, 2006. "Nominal rigidities and monetary policy in Canada," Journal of Macroeconomics, Elsevier, vol. 28(2), pages 303-325, June.
  11. S. Hendry & G-J. Zhang, 1999. "Liquidity Effects and Market Frictions," DNB Staff Reports (discontinued) 29, Netherlands Central Bank.
  12. Auray, Stéphane, 2009. "Consommation, effet de substitution intertemporelle et formation des habitudes," L'Actualité Economique, Société Canadienne de Science Economique, vol. 85(4), pages 437-473, décembre.
  13. 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.
  14. 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.

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