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Liquidity Effects and Market Frictions

  • Hendry, S.
  • Zhang, G.

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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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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  1. S. Hendry & G-J. Zhang, 1999. "Liquidity Effects and Market Frictions," DNB Staff Reports (discontinued) 29, Netherlands Central Bank.
  2. Julio J. Rotemberg, 1994. "Prices, Output and Hours: An Empirical Analysis Based on a Sticky Price Model," NBER Working Papers 4948, National Bureau of Economic Research, Inc.
  3. Cooley, T.F. & Hansen, G.D., 1991. "The Welfare Costs of Moderate Inflations," Papers 90-04, Rochester, Business - General.
  4. V.V. Chari & Lawrence J. Christiano & Martin Eichenbaum, 1995. "Inside money, outside money and short term interest rates," Working Paper Series, Macroeconomic Issues 95-13, Federal Reserve Bank of Chicago.
  5. Lawrence J. Christiano & Martin Eichenbaum & Charles L. Evans, 1996. "Sticky price and limited participation models of money: a comparison," Working Paper Series, Macroeconomic Issues WP-96-28, Federal Reserve Bank of Chicago.
  6. 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).
  7. S. Rao Aiyagari, 1994. "Macroeconomics with frictions," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Sum, pages 24-40.
  8. 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.
  9. Jang-Ok Cho & Thomas Cooley & Louis Phaneuf, 1994. "The Welfare Costs of Nominal Wage Contracting," Cahiers de recherche CREFE / CREFE Working Papers 30, CREFE, Université du Québec à Montréal, revised 22 Jan 1996.
  10. Lawrence J. Christiano & Martin Eichenbaum, 1991. "Identification and the Liquidity Effect of a Monetary Policy Shock," NBER Working Papers 3920, National Bureau of Economic Research, Inc.
  11. Armstrong, John & Black, Richard & Laxton, Douglas & Rose, David, 1998. "A robust method for simulating forward-looking models," Journal of Economic Dynamics and Control, Elsevier, vol. 22(4), pages 489-501, April.
  12. Miles S. Kimball & Michael Woodford, 1994. "The quantitative analysis of the basic neomonetarist model," Proceedings, Federal Reserve Bank of Cleveland, pages 1241-1289.
  13. Lucas, Robert Jr., 1990. "Liquidity and interest rates," Journal of Economic Theory, Elsevier, vol. 50(2), pages 237-264, April.
  14. David Andolfatto & Paul Gomme, 1997. "Monetary Policy Regimes and Beliefs," Cahiers de recherche CREFE / CREFE Working Papers 48, CREFE, Université du Québec à Montréal, revised Apr 2001.
  15. Coleman, Wilbur John, II, 1991. "Equilibrium in a Production Economy with an Income Tax," Econometrica, Econometric Society, vol. 59(4), pages 1091-1104, July.
  16. Basu, S., 1993. "Intermediate Goods and Business Cycles: Implications for Productivity and Welfare," Papers 93-23, Michigan - Center for Research on Economic & Social Theory.
  17. Lawrence J. Christiano & Martin Eichenbaum, 1992. "Liquidity effects, monetary policy and the business cycle," Working Paper Series, Macroeconomic Issues 92-15, Federal Reserve Bank of Chicago.
  18. Fung, Ben Siu-cheong & Kasumovich, Marcel, 1998. "Monetary shocks in the G-6 countries: Is there a puzzle?," Journal of Monetary Economics, Elsevier, vol. 42(3), pages 575-592, October.
  19. Marvin Goodfriend & Robert King, 1997. "The New Neoclassical Synthesis and the Role of Monetary Policy," NBER Chapters, in: NBER Macroeconomics Annual 1997, Volume 12, pages 231-296 National Bureau of Economic Research, Inc.
  20. repec:nbr:nberre:0126 is not listed on IDEAS
  21. Charles T. Carlstrom & Timothy S. Fuerst, 1996. "The benefits of interest rate targeting: a partial and a general equilibrium analysis," Economic Review, Federal Reserve Bank of Cleveland, issue Q II, pages 2-14.
  22. Fuerst, Timothy S., 1992. "Liquidity, loanable funds, and real activity," Journal of Monetary Economics, Elsevier, vol. 29(1), pages 3-24, February.
  23. Taylor, John B, 1980. "Aggregate Dynamics and Staggered Contracts," Journal of Political Economy, University of Chicago Press, vol. 88(1), pages 1-23, February.
  24. Mankiw, N. Gregory (ed.), 1997. "Monetary Policy," National Bureau of Economic Research Books, University of Chicago Press, edition 1, number 9780226503097.
  25. V. V. Chari & Patrick J. Kehoe & Ellen R. McGrattan, 1998. "Sticky price models of the business cycle: can the contract multiplier solve the persistence problem?," Staff Report 217, Federal Reserve Bank of Minneapolis.
  26. Dow, James Jr., 1995. "The demand and liquidity effects of monetary shocks," Journal of Monetary Economics, Elsevier, vol. 36(1), pages 91-115, August.
  27. Ben S.C. Fung & Marcel Kasumovich, 1997. "Monetary Shocks in the G-6 Countries: Is There a Puzzle?," Working Papers 97-7, Bank of Canada.
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