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Equilibrium Selection in a Cashless Economy with Transaction Frictions in the Bond Market

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  • M. Marzo
  • P. Zagaglia

Abstract

The present paper introduces two bonds in a standard New-Keynesian model to study the role of segmentation in bond markets for the determinacy of rational expectations equilibria. We use a strongly-separable utility function to model ‘liquid’ bonds that provide transaction services for the purchase of consumption goods. ‘Illiquid’ bonds, instead, provide the standard services of store of value. We interpret liquid bonds as mimicking short-term instruments, and illiquid bonds to represent long-dated instruments. In this simple setting, the expectation hypothesis holds after log-linearizing the model and after pricing the bonds according to an affine scheme. We assume that monetary policy follows a standard Taylor rule. In this context, the inflation targeting parameter should be higher than one for determinacy of rational expectations equilibria to be achieved. We compute an analytical solution for the bond pricing kernel. We also show that the possibility of obtaining this analytical solution depends on the type of utility function. When utility is weakly separable between consumption and liquid bonds, the Taylor principle holds conditional to the output and inflation coefficients in the Taylor rule. Achieving solution determinacy requires constraining these coefficients within bounds that depend on the structural parameters of the model, like the intertemporal elasticity of consumption substitution.

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Paper provided by Dipartimento Scienze Economiche, Universita' di Bologna in its series Working Papers with number wp769.

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Date of creation: Jul 2011
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Handle: RePEc:bol:bodewp:wp769

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  1. Bruce McGough & Glenn D. Rudebusch & John C. Williams, 2004. "Using a long-term interest rate as the monetary policy instrument," Working Paper Series, Federal Reserve Bank of San Francisco 2004-22, Federal Reserve Bank of San Francisco.
  2. Thomas Lubik & Massimiliano Marzo, 2003. "An Inventory of Simple Monetary Policy Rules in a New Keynesian Macroeconomic Model," Economics Working Paper Archive, The Johns Hopkins University,Department of Economics 500, The Johns Hopkins University,Department of Economics.
  3. Canzoneri, Matthew & Cumby, Robert & Diba, Behzad & López-Salido, David, 2011. "The role of liquid government bonds in the great transformation of American monetary policy," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 35(3), pages 282-294, March.
  4. Dixit, Avinash K & Stiglitz, Joseph E, 1975. "Monopolistic Competition and Optimum Product Diversity," The Warwick Economics Research Paper Series (TWERPS), University of Warwick, Department of Economics 64, University of Warwick, Department of Economics.
  5. Canzoneri, Matthew B. & Diba, Behzad T., 2005. "Interest rate rules and price determinacy: The role of transactions services of bonds," Journal of Monetary Economics, Elsevier, Elsevier, vol. 52(2), pages 329-343, March.
  6. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, Elsevier, vol. 12(3), pages 383-398, September.
  7. Andrew Atkeson & Patrick J. Kehoe, 2008. "On the need for a new approach to analyzing monetary policy," Staff Report, Federal Reserve Bank of Minneapolis 412, Federal Reserve Bank of Minneapolis.
  8. Stephanie Schmitt-Grohe & Martin Uribe, 2005. "Optimal Fiscal and Monetary Policy in a Medium-Scale Macroeconomic Model: Expanded Version," NBER Working Papers 11417, National Bureau of Economic Research, Inc.
  9. Leeper, Eric M., 1991. "Equilibria under 'active' and 'passive' monetary and fiscal policies," Journal of Monetary Economics, Elsevier, Elsevier, vol. 27(1), pages 129-147, February.
  10. Bullard, James & Mitra, Kaushik, 2002. "Learning about monetary policy rules," Journal of Monetary Economics, Elsevier, Elsevier, vol. 49(6), pages 1105-1129, September.
  11. Glenn Rudebusch, 1997. "Interest rates and monetary policy," FRBSF Economic Letter, Federal Reserve Bank of San Francisco, Federal Reserve Bank of San Francisco, issue jun13.
  12. Marzo, Massimiliano & Zagaglia, Paolo, 2008. "Determinacy of Interest Rate Rules with Bond Transaction Services in a Cashless Economy," Research Papers in Economics, Stockholm University, Department of Economics 2008:7, Stockholm University, Department of Economics.
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Cited by:
  1. M. Falagiarda & M. Marzo, 2012. "A DSGE model with Endogenous Term Structure," Working Papers, Dipartimento Scienze Economiche, Universita' di Bologna wp830, Dipartimento Scienze Economiche, Universita' di Bologna.

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