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Money, interest rates and the real activity

  • Hong, Hao

    ()

    (Cardiff Business School)

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This paper examines the effectiveness of monetary aggregates through various nominal interest rates by integrating the financial sector into the Cash-in-Advance (CIA) economy. The model assumes that there are two types of representative agents in the financial sector, which are: productive banks and financial intermediates. The productive banks supply a financial service, which is an exchange technology service to households and financial intermediates receive savings fund from savers and offer loans to borrowers. The monetary expansions are increased banking costs through the rate of inflation. It leads households to use more exchange credit relative to cash at the goods market. Since the number of savings funds is equal to the number of exchange credits used at the goods market, money injections are lower the nominal interest rate on saving as the saving fund increases with exchange credit. By assuming that firms are the only borrowers at the capital market from Fuerst (1992), a lower nominal interest rate on the saving fund reduces the marginal cost of labour and increases labour demand. Meanwhile, the increasing marginal cost of money through the expected inflation effect has a negative effect on labour supply. With labour demand dominating labour supply effects, both output and employment increase with monetary expansion. The paper is able to generate a decreasing nominal interest rate with an increasing money supply with an absence of limited participation monetary shocks from Lucas (1990); and by allowing firms to borrow wage bills payment from financial intermediates, it examines the positive response of aggregate output subject to monetary expansion under flexible price framework.

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Paper provided by Cardiff University, Cardiff Business School, Economics Section in its series Cardiff Economics Working Papers with number E2011/18.

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Length: 25 pages
Date of creation: Jul 2011
Date of revision:
Handle: RePEc:cdf:wpaper:2011/18
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  1. Ben Bernanke & Mark Gertler & Simon Gilchrist, 1998. "The Financial Accelerator in a Quantitative Business Cycle Framework," NBER Working Papers 6455, National Bureau of Economic Research, Inc.
  2. Cooley, Thomas F. & Hansen, Gary D., 1997. "Unanticipated Money," Economics Series 42, Institute for Advanced Studies.
  3. Fuerst, Timothy S., 1992. "Liquidity, loanable funds, and real activity," Journal of Monetary Economics, Elsevier, vol. 29(1), pages 3-24, February.
  4. Bernanke, Ben S, 1997. "Comment on "Unanticipated Money Growth and the Business Cycle Reconsidered."," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 29(4), pages 649-52, November.
  5. Benk, Szilárd & Gillman, Max & Kejak, Michal, 2005. "Credit Shocks in the Financial Deregulatory Era: Not the Usual Suspects," Cardiff Economics Working Papers E2005/13, Cardiff University, Cardiff Business School, Economics Section.
  6. Paul Gomme & Peter Rupert, 2005. "Theory, measurement, and calibration of macroeconomic models," Working Paper 0505, Federal Reserve Bank of Cleveland.
  7. Szilárd Benk & Max Gillman & Michal Kejak, 2006. " Money Velocity in an Endogenous Growth Business Cycle with Credit Shocks," CDMA Conference Paper Series 0604, Centre for Dynamic Macroeconomic Analysis.
  8. Svensson, Lars E O, 1985. "Money and Asset Prices in a Cash-in-Advance Economy," Journal of Political Economy, University of Chicago Press, vol. 93(5), pages 919-44, October.
  9. Thomas F. Cooley & Gary D. Hansen, 1997. "Unanticipated money growth and the business cycle reconsidered," Proceedings, Federal Reserve Bank of Cleveland, issue Nov, pages 624-652.
  10. 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.
  11. Lucas, Robert Jr., 1990. "Liquidity and interest rates," Journal of Economic Theory, Elsevier, vol. 50(2), pages 237-264, April.
  12. Cooley, Thomas F. & Hansen, Gary D., 1998. "The role of monetary shocks in equilibrium business cycle theory: Three examples," European Economic Review, Elsevier, vol. 42(3-5), pages 605-617, May.
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