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Liquidity Effects and Market Frictions

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  • Scott Hendry
  • Guang-Jia Zhang

Abstract

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.

Suggested Citation

  • Scott Hendry & Guang-Jia Zhang, 1998. "Liquidity Effects and Market Frictions," Staff Working Papers 98-11, Bank of Canada.
  • Handle: RePEc:bca:bocawp:98-11
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    Cited by:

    1. Niki Papadopoulou, 2004. "Sticky Prices, Limited Participation or Both?," Working Papers 2004_3, Business School - Economics, University of Glasgow.
    2. David Laidler, 1999. "The Quantity of Money and Monetary Policy," Staff Working Papers 99-5, Bank of Canada.
    3. Vladimir Turetsky & Valery Y. Glizer, 2005. "Continuous Feedback Control Strategy With Maximal Capture Zone In A Class Of Pursuit Games," International Game Theory Review (IGTR), World Scientific Publishing Co. Pte. Ltd., vol. 7(01), pages 1-24.
    4. Patureau, Lise, 2007. "Pricing-to-market, limited participation and exchange rate dynamics," Journal of Economic Dynamics and Control, Elsevier, vol. 31(10), pages 3281-3320, October.
    5. Chung, Kyuil, 2009. "Does the liquidity effect guarantee a positive term premium?," Economic Modelling, Elsevier, vol. 26(5), pages 893-903, September.
    6. Peter Ireland & Niki Papadopoulou, 2004. "Sticky Prices vs. Limited Participation: What Do We Learn From the Data?," Money Macro and Finance (MMF) Research Group Conference 2004 79, Money Macro and Finance Research Group.
    7. Stracca, Livio, 2001. "Does liquidity matter? Properties of a synthetic divisia monetary aggregate in the euro area," Working Paper Series 79, European Central Bank.
    8. Karamé, Frédéric & Patureau, Lise & Sopraseuth, Thepthida, 2008. "Limited participation and exchange rate dynamics: Does theory meet the data?," Journal of Economic Dynamics and Control, Elsevier, vol. 32(4), pages 1041-1087, April.
    9. David Longworth & Brian O´Reilly, 2002. "The Monetary Policy Transmission Mechanism and Policy Rules in Canada," Central Banking, Analysis, and Economic Policies Book Series, in: Norman Loayza & Klaus Schmidt-Hebbel & Norman Loayza (Series Editor) & Klaus Schmidt-Hebbel (Series (ed.),Monetary Policy: Rules and Transmission Mechanisms, edition 1, volume 4, chapter 13, pages 357-392, Central Bank of Chile.
    10. Lishun Zeng & Shinji Mizuno, 2013. "On The Generalized Mirrored Scheme For Double Round Robin Tournaments In Sports Scheduling," Asia-Pacific Journal of Operational Research (APJOR), World Scientific Publishing Co. Pte. Ltd., vol. 30(03), pages 1-16.
    11. Stracca, Livio, 2001. "Does liquidity matter? Properties of a synthetic divisia monetary aggregate in the euro area," Working Paper Series 0079, European Central Bank.
    12. Dib, Ali, 2006. "Nominal rigidities and monetary policy in Canada," Journal of Macroeconomics, Elsevier, vol. 28(2), pages 303-325, June.
    13. Shamik Dhar & Stephen P Millard, 2000. "A limited participation model of the monetary transmission mechanism in the United Kingdom," Bank of England working papers 117, Bank of England.
    14. Niki Papadopoulou, 2006. "Sticky Prices vs. Limited Participation:What Do We Learn From the Data?," Computing in Economics and Finance 2006 418, Society for Computational Economics.
    15. Shamik Dhar & Stephen P Millard, 2000. "How well does a limited participation model of the monetary transmission mechanism match UK data?," Bank of England working papers 118, Bank of England.
    16. Hendry, Scott & Zhang, Guang-Jia, 2001. "Liquidity Effects and Market Frictions," Journal of Macroeconomics, Elsevier, vol. 23(2), pages 153-176, April.
    17. Auray, Stéphane, 2009. "Consommation, effet de substitution intertemporelle et formation des habitudes," L'Actualité Economique, Société Canadienne de Science Economique, vol. 85(4), pages 437-473, décembre.
    18. Anders Richtnér & Pär Åhlström, 2006. "Influences On Organisational Slack In New Product Development Projects," International Journal of Innovation Management (ijim), World Scientific Publishing Co. Pte. Ltd., vol. 10(04), pages 375-406.

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    More about this item

    Keywords

    Transmission of monetary policy;

    JEL classification:

    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit

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