Liquidity, Inflation, and Monetary Policy
In standard monetary models nominal interest rates should be decreased in response to a switch to a lower inflation target. This paper considers this interaction between inflation and nominal interest rates in a dynamic model of liquidity. In a repeated Diamond&Dybvig economy a financial intermediation sector provides those agents with money/liquidity who urgently need it and saves for those who do not. I show when a lower inflation target requires a higher nominal interest rate. I then calibrate the model. The model fits the data very well and the response of inflation to a permanent increase in nominal interest rates is negative if nominal interest rates are low (`the market is liquid') and positive if nominal interest rates are high (`the market is illiquid')
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|Date of creation:||03 Dec 2006|
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