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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
Date of revision:
Handle: RePEc:red:sed012:1070
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. Chatterjee, Satyajit & Corbae, Dean, 1992. "Endogenous Market Participation and the General Equilibrium Value of Money," Journal of Political Economy, University of Chicago Press, vol. 100(3), pages 615-46, June.
  2. Robert G. King & Julia K. Thomas, 2004. "Partial Adjustment Without Apology," Working Papers 2004/15, Turkish Economic Association.
  3. Lawrence J. Christiano & Martin Eichenbaum & Charles L. Evans, 1998. "Monetary Policy Shocks: What Have We Learned and to What End?," NBER Working Papers 6400, National Bureau of Economic Research, Inc.
  4. 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.
  5. Julia K. Thomas, . "Is Lumpy Investment Relevant for the Business Cycle?," GSIA Working Papers 1998-E250, Carnegie Mellon University, Tepper School of Business.
  6. 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.
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  9. Annette Vissing-Jorgensen, 2002. "Towards an Explanation of Household Portfolio Choice Heterogeneity: Nonfinancial Income and Participation Cost Structures," NBER Working Papers 8884, National Bureau of Economic Research, Inc.
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  13. 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.
  14. Chiu, Jonathan, 2014. "Endogenously Segmented Asset Market In An Inventory-Theoretic Model Of Money Demand," Macroeconomic Dynamics, Cambridge University Press, vol. 18(02), pages 438-472, March.
  15. Emi Nakamura & Jón Steinsson, 2008. "Five Facts about Prices: A Reevaluation of Menu Cost Models," The Quarterly Journal of Economics, MIT Press, vol. 123(4), pages 1415-1464, November.
  16. Julio J. Rotemberg, 1982. "A Monetary Equilibrium Model with Transactions Costs," NBER Working Papers 0978, National Bureau of Economic Research, Inc.
  17. Williamson, Stephen D., 2008. "Monetary policy and distribution," Journal of Monetary Economics, Elsevier, vol. 55(6), pages 1038-1053, September.
  18. 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.
  19. Fernando Alvarez & Andrew Atkeson & Chris Edmond, 2008. "Sluggish responses of prices and inflation to monetary shocks in an inventory model of money demand," Staff Report 417, Federal Reserve Bank of Minneapolis.
  20. 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.
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