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Markets Segmentation and the Hump-Shaped Response of Output to Monetary Policy Shocks

  • Filippo Occhino

After a contractionary monetary policy shock, aggregate output decreases over time, with a trough after four to eight quarters. This paper replicates the delayed response of output using a segmented markets model where some households do not participate in financial markets. A contractionary monetary policy shock is modeled as an unanticipated increase in the nominal interest rate. Firms need money to finance production and workers receive wages with delay. An increase in the nominal interest rate, then, shifts both the labor demand and the labor supply curve to the left, and decreases the equilibrium labor and production. In a benchmark full participation model, the effect is strongest in the impact period and decays over time. When some households do not participate in financial markets, however, the monetary policy shock has an additional liquidity effect, increases the real interest rate, increases the growth rates of consumption and leisure of participating households, and decreases the growth rate of their labor supply. When markets are segmented enough, the trough of the equilibrium labor and output response occurs after several quarters. The model is able to replicate the sign, the magnitude and the persistence of the responses of output, money, prices, wages, and interest rates. In particular, a contractionary shock increases the interest rates, and decreases output, money, prices and the real wage. The model can replicate the increase in the real interest rate together with the decrease in the output growth rate. The inflation rate is endogenously persistent.

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Paper provided by Society for Economic Dynamics in its series 2004 Meeting Papers with number 295.

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Date of creation: 2004
Date of revision:
Handle: RePEc:red:sed004:295
Contact details of provider: Postal: Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA
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  1. Christiano, Lawrence J & Eichenbaum, Martin, 1992. "Liquidity Effects and the Monetary Transmission Mechanism," American Economic Review, American Economic Association, vol. 82(2), pages 346-53, May.
  2. Cooley, T.F. & Hansen, G.D., 1988. "The Inflation Tax In A Real Business Cycle Model," RCER Working Papers 155, University of Rochester - Center for Economic Research (RCER).
  3. Uhlig, Harald, 2005. "What are the effects of monetary policy on output? Results from an agnostic identification procedure," Journal of Monetary Economics, Elsevier, vol. 52(2), pages 381-419, March.
  4. Christiano, Lawrence J. & Eichenbaum, Martin & Evans, Charles L., 1999. "Monetary policy shocks: What have we learned and to what end?," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 2, pages 65-148 Elsevier.
  5. 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.
  6. Fuerst, Timothy S., 1992. "Liquidity, loanable funds, and real activity," Journal of Monetary Economics, Elsevier, vol. 29(1), pages 3-24, February.
  7. Ben S. Bernanke & Ilian Mihov, 1995. "Measuring Monetary Policy," NBER Working Papers 5145, National Bureau of Economic Research, Inc.
  8. Lucas, Robert Jr., 1990. "Liquidity and interest rates," Journal of Economic Theory, Elsevier, vol. 50(2), pages 237-264, April.
  9. David B. Gordon & Eric M. Leeper, 1992. "The dynamic impacts of monetary policy: an exercise in tentative identification," FRB Atlanta Working Paper 92-13, Federal Reserve Bank of Atlanta.
  10. Christiano, Lawrence J & Eichenbaum, Martin & Evans, Charles, 1996. "The Effects of Monetary Policy Shocks: Evidence from the Flow of Funds," The Review of Economics and Statistics, MIT Press, vol. 78(1), pages 16-34, February.
  11. Filippo Occhino, 2004. "Modeling the Response of Money and Interest Rates to Monetary Policy Shocks: A Segmented Markets Approach," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 7(1), pages 181-197, January.
  12. Grossman, Sanford & Weiss, Laurence, 1983. "A Transactions-Based Model of the Monetary Transmission Mechanism," American Economic Review, American Economic Association, vol. 73(5), pages 871-80, December.
  13. Occhino, Filippo, 2008. "Market Segmentation And The Response Of The Real Interest Rate To Monetary Policy Shocks," Macroeconomic Dynamics, Cambridge University Press, vol. 12(05), pages 591-618, November.
  14. Strongin, Steven, 1995. "The identification of monetary policy disturbances explaining the liquidity puzzle," Journal of Monetary Economics, Elsevier, vol. 35(3), pages 463-497, June.
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