Understanding a New Keynesian Model with Liquidity

The Global Financial Crisis of 2007--2009 and its aftermath have called for a rethink of the role of money in shaping business cycle fluctuations. To this end, this paper studies a New Keynesian model with money (liquidity). In the model, agents hold government money and other financial assets. However, there is a "short rate disconnect" (i.e., an interest rate spread) between the policy rate on money and the interest rate on household's savings. The paper shows that there exists a meaningful "liquidity effect" that is quantitatively significant for the macroeconomy. As the spread increases, so does the price of liquidity. In a model where consumption and money are complements, such an increase in the opportunity cost of money induces agents to consume less and work less. Both the effects imply that the real wage can fall, which in turn puts downward pressures on inflation via the New Keynesian Phillips curve. The fall in inflation makes the monetary authority cut the nominal interest rates by more, but at the cost of increasing the spread even further. In addition, the paper compares the dynamic responses to technology shocks and monetary policy shocks for the model with liquidity and the standard New Keynesian model. The results show that the responses can be quantitatively different for the two models. Finally, this paper studies the interaction between the liquidity effect and monetary policy, highlighting the liquidity effect that can play in business cycles.