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Firms’ Money Demand and Monetary Policy

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  • Bafile, Romina
  • Piergallini, Alessandro

Abstract

Standard New Keynesian models for monetary policy analysis are "cashless". When the nominal interest rate is the central bank's operating instrument, the LM equation is endogenous and, it is argued, can be ignored. The modern theoretical and quantitative debate on the importance of money for the conduct of monetary policy, however, overlooks firms' money demand. Working in an otherwise baseline New Keynesian setup, this paper shows that the monetary policy transmission mechanism is critically affected by the firms' money demand choice. Specifically, we prove that equilibrium determinacy may require either an active interest-rate policy (i.e., overreacting to inflation) or a passive interest-rate policy (i.e., underreacting to inflation), depending on the elasticity of production with respect to real money balances. We then calibrate the model to U.S. quarterly data and develop a sensitivity analysis in order to investigate the quantitative implications of our theoretical results. We find that macroeconomic stability is more likely to be guaranteed under an active, although not overly aggressive, monetary-policy stance.

Suggested Citation

  • Bafile, Romina & Piergallini, Alessandro, 2011. "Firms’ Money Demand and Monetary Policy," MPRA Paper 29028, University Library of Munich, Germany.
  • Handle: RePEc:pra:mprapa:29028
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    Keywords

    Firms’ Money Demand; Interest-Rate Policy.;

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E41 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Demand for Money

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