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On the Relevance of Open Market Operations

  • Andreas Schabert

This paper reexamines the role of open market operations for short-run effects of monetary policy in a New Keynesian framework. The central bank supplies money in exchange for securities that are discounted with the short-run nominal interest rate, while money demand is induced by a liquidity constraint. We allow for a legal restriction by which only government bonds are eligible. Their supply is bounded by fiscal policy that is assumed to be Ricardian. If public debt is dominated in rate of return by private debt, open market operations matter, and an endogenous liquidity premium and a liquidity effect arise. Nominal interest rate setting (including a peg) is then associated with price level and equilibrium uniqueness, regardless whether prices are flexible or set in a staggered way. Thus, the legal restriction overcomes indeterminacies due to an unbounded money supply, as implied by the real bills doctrine. Moreover, it facilitates constant money growth and interest rate policy to be equivalent.

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Paper provided by University of Cologne, Department of Economics in its series Working Paper Series in Economics with number 4.

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Date of creation: 15 Dec 2003
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Handle: RePEc:kls:series:0004
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  13. Bennett McCallum, 1999. "Role of the Minimal State Variable Criterion in Rational Expectations Models," International Tax and Public Finance, Springer, vol. 6(4), pages 621-639, November.
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  17. Richard Clarida & Jordi Galí & Mark Gertler, 1997. "The science of monetary policy: A new Keynesian perspective," Economics Working Papers 356, Department of Economics and Business, Universitat Pompeu Fabra, revised Apr 1999.
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  19. Lucas, Robert Jr., 1990. "Liquidity and interest rates," Journal of Economic Theory, Elsevier, vol. 50(2), pages 237-264, April.
  20. Bansal, Ravi & Coleman, Wilbur John, II, 1996. "A Monetary Explanation of the Equity Premium, Term Premium, and Risk-Free Rate Puzzles," Journal of Political Economy, University of Chicago Press, vol. 104(6), pages 1135-71, December.
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