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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 Staff 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. Hendry, S. & Zhang, G., 1998. "Liquidity Effects and Market Frictions," Staff Working Papers 98-11, Bank of Canada.
  2. Thomas F. Cooley & Gary D. Hansen, 1987. "The Inflation Tax in a Real Business Cycle Model," UCLA Economics Working Papers 496, UCLA Department of Economics.
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  9. 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.
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  18. Dow, James Jr., 1995. "The demand and liquidity effects of monetary shocks," Journal of Monetary Economics, Elsevier, vol. 36(1), pages 91-115, August.
  19. Michael Dotsey & Peter N. Ireland, 1994. "Liquidity effects and transactions technologies," Proceedings, Federal Reserve Bank of Cleveland, pages 1441-1471.
  20. 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.
  21. S. Rao Aiyagari, 1994. "Macroeconomics with frictions," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Sum, pages 24-40.
  22. 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.
  23. Fuerst, Timothy S., 1992. "Liquidity, loanable funds, and real activity," Journal of Monetary Economics, Elsevier, vol. 29(1), pages 3-24, February.
  24. Lucas, Robert Jr., 1990. "Liquidity and interest rates," Journal of Economic Theory, Elsevier, vol. 50(2), pages 237-264, April.
  25. Mankiw, N. Gregory (ed.), 1997. "Monetary Policy," National Bureau of Economic Research Books, University of Chicago Press, edition 1, number 9780226503097.
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