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Inflation and Interest Rates with Endogenous Market Segmentation

  • Julia Thomas

    (The Ohio State University)

  • Aubhik Khan

    (Ohio State University)

We examine a monetary economy wherein endogenous asset market segmentation permits the extent of household participation in open market operations to vary smoothly with changes in aggregate conditions. While we impose no stickiness at the microeconomic level in either prices or portfolio adjustment, we find that our flexible asset market segmentation can deliver gradual adjustment in the aggregate price level following a monetary shock and thus persistent non-neutralities. In our model economy, 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, asset markets are endogenously segmented. Because our households can alter the timing of their trading activities, the extent of market segmentation varies over time in response to real and nominal shocks, as does the distribution of real balances across households. We show that this added flexibility can substantially reinforce the sluggishness in aggregate price adjustment following a monetary shock, relative to models with exogenously segmented asset markets, and it can transform dramatic, transitory changes in real and nominal interest rates into more moderate and persistent liquidity effects. We also show that, following an endowment shock, changes in households' portfolio adjustment timing generate persistence in inflation and interest rates that is otherwise absent. Finally, we show that these changes can reshape aggregate quantity dynamics in a version of the model with production, generating hump-shaped responses in employment and output following a monotone shock to productivity.

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Paper provided by Society for Economic Dynamics in its series 2012 Meeting Papers with number 1070.

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Date of creation: 2012
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Handle: RePEc:red:sed012:1070
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Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA

Web page: http://www.EconomicDynamics.org/
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  1. Stephen D. Williamson, 2005. "Monetary Policy and Distribution," 2005 Meeting Papers 379, Society for Economic Dynamics.
  2. Robert G. King & Julia K. Thomas, 2006. "Partial Adjustment Without Apology," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 47(3), pages 779-809, 08.
  3. 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.
  4. V. V. Chari & Patrick J. Kehoe & Ellen R. McGrattan, 2000. "Sticky Price Models of the Business Cycle: Can the Contract Multiplier Solve the Persistence Problem?," Econometrica, Econometric Society, vol. 68(5), pages 1151-1180, September.
  5. Fernando Alvarez & Robert E. Lucas & Warren E. Weber, 2001. "Interest Rates and Inflation," American Economic Review, American Economic Association, vol. 91(2), pages 219-225, May.
  6. Julio J. Rotemberg, 1982. "A Monetary Equilibrium Model with Transactions Costs," NBER Working Papers 0978, National Bureau of Economic Research, Inc.
  7. Michael Dotsey & Robert G. King & Alexander L. Wolman, 1999. "State-Dependent Pricing and the General Equilibrium Dynamics of Money and Output," The Quarterly Journal of Economics, Oxford University Press, vol. 114(2), pages 655-690.
  8. 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.
  9. Julia K. Thomas, 2002. "Is Lumpy Investment Relevant for the Business Cycle?," Journal of Political Economy, University of Chicago Press, vol. 110(3), pages 508-534, June.
  10. 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.
  11. Fernando Alvarez & Andrew Atkeson & Chris Edmond, 2003. "On the Sluggish Response of Prices to Money in an Inventory-Theoretic Model of Money Demand," NBER Working Papers 10016, National Bureau of Economic Research, Inc.
  12. Fernando Alvarez & Andrew Atkeson & Patrick J. Kehoe, 2002. "Money, Interest Rates, and Exchange Rates with Endogenously Segmented Markets," Journal of Political Economy, University of Chicago Press, vol. 110(1), pages 73-112, February.
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