Inflation, Employment and Interest Rates in an Economy with Endogenous Market Segmentation

Inflation, Employment and Interest Rates in an Economy with Endogenous Market Segmentation Aubhik Khan, Federal Reserve Bank of Philadelphia Julia K. Thomas, University of Minnesota We examine a monetary economy where households incur fixed transactions costs when exchanging bonds and money and, as a result, carry money balances in excess of current spending to limit the frequency of such trades. As only a fraction of households choose to actively trade bonds and money at any given time, the market is endogenously segmented. Moreover, because households in our model economy have the ability to alter the timing of their trading activities, the extent of market segmentation varies over time in response to real and nominal shocks. In endowment economies, this added flexibility can substantially reinforce both sluggishness in aggregate price adjustment and the persistence of liquidity effects in real and nominal interest rates relative to that seen in models with exogenously segmented markets. Small changes in the number of households actively participating in open market operations lead to changes in the distribution of money holdings across households that differ markedly from those in existing monetary models where the degree of market segmentation is fixed: (1) When shocks to money growth rates are transitory, these changes in distribution add persistence to inflation, and they transform sharp temporary movements in real interest rates into more moderate and gradual responses. (2) Under persistent money growth shocks, they imply prolonged liquidity effects in both real and nominal interest rates, as well as more gradual price adjustment. (3) Finally, when monetary policy is governed by an active Taylor rule, persistent real shocks cause persistent movements in inflation and interest rates only if households are allowed to respond to such shocks with changes in the timing of their portfolio reallocations. Our existing findings suggest that monetary models with endogenous market segmentation may be useful toward a better understanding of the relations between movements in real and nominal aggregate series observed in the data. Introducing production into this environment, we examine the extent to which the real effects of monetary policy, manifested through persistent changes in real interest rates and the distribution of consumption across households, are robust to endogenous responses in aggregate employment and investment. In doing so, we establish whether endogenous market segmentation can transmit these real effects beyond mere reallocation into persistent changes in aggregate output, employment and wages.