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Firms’ Money Demand and Monetary Policy

  • Bafile, Romina
  • Piergallini, Alessandro

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.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 29028.

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Date of creation: 21 Feb 2011
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Handle: RePEc:pra:mprapa:29028
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  1. Mulligan, Casey B, 1997. "Scale Economies, the Value of Time, and the Demand for Money: Longitudinal Evidence from Firms," Journal of Political Economy, University of Chicago Press, vol. 105(5), pages 1061-79, October.
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  3. Benhabib, J. & Schmitt-Grohe, S. & Uribe, M., 1998. "Monetary Policy and Multiple Equilibria," Working Papers 98-02, C.V. Starr Center for Applied Economics, New York University.
  4. Fischer, Stanley, 1974. "Money and the Production Function," Economic Inquiry, Western Economic Association International, vol. 12(4), pages 517-33, December.
  5. Michael Woodford, 2007. "How Important is Money in the Conduct of Monetary Policy?," Levine's Working Paper Archive 122247000000001419, David K. Levine.
  6. Khan, Ashfaque H & Ahmad, Mushtaq, 1985. "Real Money Balances in the Production Function of a Developing Country," The Review of Economics and Statistics, MIT Press, vol. 67(2), pages 336-40, May.
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  8. Bover, Olympia & Watson, Nadine, 2005. "Are there economies of scale in the demand for money by firms? Some panel data estimates," Journal of Monetary Economics, Elsevier, vol. 52(8), pages 1569-1589, November.
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  11. Julio J. Rotemberg & Michael Woodford, 1999. "Interest Rate Rules in an Estimated Sticky Price Model," NBER Chapters, in: Monetary Policy Rules, pages 57-126 National Bureau of Economic Research, Inc.
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  18. Nguyen, Hong V, 1986. "Money in the Aggregate Production Function: Reexamination and Further Evidence," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 18(2), pages 141-51, May.
  19. Dennis, Enid & Smith, V Kerry, 1978. "A Neoclassical Analysis of the Demand for Real Cash Balances by Firms," Journal of Political Economy, University of Chicago Press, vol. 86(5), pages 793-813, October.
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  31. repec:nbr:nberbk:tayl99-1 is not listed on IDEAS
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