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Market Segmentation and the 'Hump-Shaped' Response of Output to Monetary Policy Shocks

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  • Filippo Occhino

    ()
    (Rutgers University)

Abstract

After a contractionary monetary policy shock, aggregate output decreases over time, with a trough after four to eight quarters. In a benchmark full participation model, the effect of a contractionary shock on output is strongest in the impact period and decays over time. When some households do not participate in financial markets, however, the shock has an additional liquidity effect, it increases the real interest rate, and it decreases the growth rate of the participants' labor supply. As a result, the trough of the equilibrium aggregate labor and output response occurs after several quarters. The model is able to replicate the sign, the magnitude and the persistence of the responses of output, money, and interest rates. Abstract: In the data, after a contractionary monetary policy shock aggregate output decreases over time, with a trough after four to eight quarters. This paper replicates the `hump-shaped' response of output with a segmented markets model where part of the households are excluded from financial markets. A contractionary monetary policy shock is modeled as an unanticipated increase in the short-term nominal interest rate. Since households and firms need cash-in-advance to purchase consumption and hire labor, an increase in the nominal interest rate discourages the households' consumption demand and labor supply, and the firms' labor demand. In a benchmark full participation model, the effect is strongest in the impact period, and decays over time. When markets are segmented, however, the shock has an additional liquidity effect, increasing the real interest rate above fundamentals, and decreasing the growth rate of the participants' labor supply. As a result, the response of the aggregate labor and output has a trough several quarters after the shock. The model is able to replicate the sign, the magnitude and the persistence of the responses of output, money, prices and interest rates. It can generate a positive response of the real interest rate together with a negative response of the output growth rate.

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Bibliographic Info

Paper provided by Rutgers University, Department of Economics in its series Departmental Working Papers with number 200410.

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Length: 20 pages
Date of creation: 09 Aug 2004
Date of revision:
Handle: RePEc:rut:rutres:200410

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Keywords: limited participation; segmented markets; hump-shaped delayed response; monetary policy shocks; persistence;

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  1. Strongin, Steven, 1995. "The identification of monetary policy disturbances explaining the liquidity puzzle," Journal of Monetary Economics, Elsevier, vol. 35(3), pages 463-497, June.
  2. Ben S. Bernanke & Ilian Mihov, 1995. "Measuring monetary policy," Working Papers in Applied Economic Theory 95-09, Federal Reserve Bank of San Francisco.
  3. Occhino, Filippo, 2008. "Market Segmentation And The Response Of The Real Interest Rate To Monetary Policy Shocks," Macroeconomic Dynamics, Cambridge University Press, vol. 12(05), pages 591-618, November.
  4. Uhlig, Harald, 2005. "What are the effects of monetary policy on output? Results from an agnostic identification procedure," Journal of Monetary Economics, Elsevier, vol. 52(2), pages 381-419, March.
  5. Cooley, T.F. & Hansen, G.D., 1988. "The Inflation Tax In A Real Business Cycle Model," RCER Working Papers 155, University of Rochester - Center for Economic Research (RCER).
  6. Lawrence J. Christiano & Martin Eichenbaum & Charles Evans, 1994. "The effects of monetary policy shocks: evidence from the flow of funds," Proceedings, Federal Reserve Bank of Dallas, issue Apr.
  7. Lawrence J. Christiano & Martin Eichenbaum & Charles L. Evans, 1998. "Monetary Policy Shocks: What Have We Learned and to What End?," NBER Working Papers 6400, National Bureau of Economic Research, Inc.
  8. Filippo Occhino, 2004. "Modeling the Response of Money and Interest Rates to Monetary Policy Shocks: A Segmented Markets Approach," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 7(1), pages 181-197, January.
  9. Lawrence J. Christiano & Martin Eichenbaum, 1992. "Liquidity effects and the monetary transmission mechanism," Staff Report 150, Federal Reserve Bank of Minneapolis.
  10. Fuerst, Timothy S., 1992. "Liquidity, loanable funds, and real activity," Journal of Monetary Economics, Elsevier, vol. 29(1), pages 3-24, February.
  11. David B. Gordon & Eric M. Leeper, 1992. "The dynamic impacts of monetary policy: an exercise in tentative identification," Working Paper 92-13, Federal Reserve Bank of Atlanta.
  12. Lucas, Robert Jr., 1990. "Liquidity and interest rates," Journal of Economic Theory, Elsevier, vol. 50(2), pages 237-264, April.
  13. Grossman, Sanford & Weiss, Laurence, 1983. "A Transactions-Based Model of the Monetary Transmission Mechanism," American Economic Review, American Economic Association, vol. 73(5), pages 871-80, December.
  14. Eric M. Leeper & Christopher A. Sims & Tao Zha, 1996. "What Does Monetary Policy Do?," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 27(2), pages 1-78.
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