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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. Dotsey, Michael & Ireland, Peter, 1995. "Liquidity Effects and Transactions Technologies," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 27(4), pages 1441-57, November.
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Citations

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Cited by:
  1. Hendry, S. & Zhang, G., 1998. "Liquidity Effects and Market Frictions," Working Papers 98-11, Bank of Canada.
  2. Karamé, Frédéric & Patureau, Lise & Sopraseuth, Thepthida, 2008. "Limited participation and exchange rate dynamics: Does theory meet the data?," Journal of Economic Dynamics and Control, Elsevier, vol. 32(4), pages 1041-1087, April.
  3. 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.
  4. Chung, Kyuil, 2009. "Does the liquidity effect guarantee a positive term premium?," Economic Modelling, Elsevier, vol. 26(5), pages 893-903, September.
  5. Peter Ireland & Niki Papadopoulou, 2004. "Sticky Prices vs Limited Participation: What do we Learn from the Data?," Working Papers 2004_4, Business School - Economics, University of Glasgow.
  6. 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.
  7. Laidler, David, 1999. "The Quantity of Money and Monetary Policy," Working Papers 99-5, Bank of Canada.
  8. 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.
  9. Dib, Ali, 2006. "Nominal rigidities and monetary policy in Canada," Journal of Macroeconomics, Elsevier, vol. 28(2), pages 303-325, June.
  10. Niki Papadopoulou, 2004. "Sticky Prices, Limited Participation or Both?," Working Papers 2004_3, Business School - Economics, University of Glasgow.
  11. Stracca, Livio, 2001. "Does liquidity matter? Properties of a synthetic divisia monetary aggregate in the euro area," Working Paper Series 0079, European Central Bank.
  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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