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Labour Markets, Liquidity, and Monetary Policy Regimes

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  • David Andolfatto
  • Scott Hendry
  • Kevin Moran

Abstract

We develop an equilibrium model of the monetary policy transmission mechanism that highlights information frictions in the market for money and search frictions in the labour market. The information friction increases the persistence in the response of interest rates following monetary policy regime shifts. This occurs because agents have incomplete information about the nature of the shifts and optimally update their inflation forecasts using an `adaptive' expectations rule. The search friction transmits the interest rate movements to the labour market by affecting job creation activities; together, the two frictions imply that unemployment reacts very gradually to monetary policy shocks.

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Paper provided by Bank of Canada in its series Working Papers with number 02-32.

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Length: 50 pages Abstract: We develop an equilibrium model of the monetary policy transmission mechanism that highlights information frictions in the market for money and search frictions in the market for labour. A change in monetary policy regime, modelled here as an exogenous reduction in the long-run target for the money-growth rate, results in a large and persistent increase in the interest rate owing to a persistent shortfall in liquidity. This persistent liquidity effect occurs because of the limited information that individuals have concerning the nature of the shock, which implies that individuals optimally update their inflation forecasts using an adaptive expectations rule. The subsequent period of high interest rates curtails job-creation activities in the business sector, making it more difficult for the unemployed to find suitable job matches; employment bottoms out two to three quarters after the shock. In the long run, however, employment rises above its initial level, primarily because of the lower long-run interest rates associated with a tight-money regime.
Date of creation: 2002
Date of revision:
Handle: RePEc:bca:bocawp:02-32
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Keywords: Transmission of monetary policy; Uncertainty and monetary policy;

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Find related papers by JEL classification:
  • E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates
  • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit

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Cited by:

  1. Aleksander Berentsen & Guido Menzio & Randall Wright, 2011. "Inflation and Unemployment in the Long Run," American Economic Review, American Economic Association, vol. 101(1), pages 371-98, February.
  2. David Andolfatto & Scott Hendry & Kevin Moran, 2005. "Are Inflation Expectations Rational?," Macroeconomics 0501002, EconWPA.
  3. Sylvain Dessy & Safa Ragued, 2013. "Multidimensional Poverty Targeting," Cahiers de recherche 1340, CIRPEE.
  4. Robert Amano & Scott Hendry, 2003. "Inflation persistence and costly market share adjustment: a preliminary analysis," BIS Papers chapters, in: Bank for International Settlements (ed.), Monetary policy in a changing environment, volume 19, pages 134-146 Bank for International Settlements.

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