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Monetary Policy With Liquidity Frictions

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  • Oscar Mauricio Valencia

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Abstract

This paper explores the welfare effects of a reduction in the inflation rates in an environment of incomplete markets. We built a dynamic heterogeneous agent model that features idiosyncratic risks in the labor supply and liquidity frictions. The model shows that a disinflation policy results in an income reallocation among debtors and lenders. The changes in the capital returns conveys variations in the precautionary savings and hence, an intertemporal redistribution of wealth and income. The welfare implications are develop according to the incomplete market features and the money plays a role of smoothing consumption when the agents faces income variability without state contingent insurance. The model is calibrated for the Colombian economy in such a way that disinflation episodes are replicated. Early results show that the disinflation monetary policy leads to improvements of liquidity in the economy because the money holdings are used by the agents for wealth transfer over time. This paper shows quantitative evidence in which disinflation facts are associated with increments in the average real money holdings and average consumption. In addition, the volatility of consumption is reduced as the inflation rate falls, while the volatility of money holdings increases (i.e. precautionary demand for money balance).

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File URL: http://economia.uniandes.edu.co/publicaciones/d2006-38.pdf
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Paper provided by UNIVERSIDAD DE LOS ANDES-CEDE in its series DOCUMENTOS CEDE with number 003252.

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Length: 30
Date of creation: 15 Oct 2006
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Handle: RePEc:col:000089:003252

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Keywords: Monetary policy; heterogeneous agents; stationary distribution;

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  1. S. Rao Aiyagari, 1993. "Uninsured idiosyncratic risk and aggregate saving," Working Papers, Federal Reserve Bank of Minneapolis 502, Federal Reserve Bank of Minneapolis.
  2. Andrew B. Abel, 1985. "Dynamic Behavior of Capital Accumulation in a Cash-in-Advance Model," NBER Working Papers 1549, National Bureau of Economic Research, Inc.
  3. Akyol, Ahmet, 2004. "Optimal monetary policy in an economy with incomplete markets and idiosyncratic risk," Journal of Monetary Economics, Elsevier, Elsevier, vol. 51(6), pages 1245-1269, September.
  4. Zeldes, Stephen P, 1989. "Consumption and Liquidity Constraints: An Empirical Investigation," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 97(2), pages 305-46, April.
  5. Bewley, Truman, 1977. "The permanent income hypothesis: A theoretical formulation," Journal of Economic Theory, Elsevier, vol. 16(2), pages 252-292, December.
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