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Modeling Monetary Policy

  • Samuel Reynard
  • Andreas Schabert

We develop a macroeconomic framework where money is supplied against only few eligible securities in open market operations. The relationship between the policy rate, expected inflation and consumption growth is affected by money market conditions, i.e. the varying liquidity value of eligible assets and the associated risk. This induces a liquidity premium, which explains the observed systematic wedge between the policy rate and consumption Euler interest rate that standard models equate. It further implies a dampened response of consumption to policy rate shocks that is humpshaped when we account for realistic central bank transfers and the dynamics of bond holdings.

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Paper provided by Swiss National Bank in its series Working Papers with number 2010-04.

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Length: 46 pages
Date of creation: 2010
Date of revision:
Handle: RePEc:snb:snbwpa:2010-04
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  1. Yun, Tack, 1996. "Nominal price rigidity, money supply endogeneity, and business cycles," Journal of Monetary Economics, Elsevier, vol. 37(2-3), pages 345-370, April.
  2. Lawrence J. Christiano & Martin Eichenbaum & Charles L. Evans, 2001. "Nominal rigidities and the dynamic effects of a shock to monetary policy," Working Paper 0107, Federal Reserve Bank of Cleveland.
  3. Matthew Canzoneri & Robert Cumby & Behzad Diba & David López-Salido, 2008. "Monetary aggregates and liquidity in a neo-Wicksellian framework," Working Paper Research 141, National Bank of Belgium.
  4. Bengt Holmström, 2001. "LAPM: A Liquidity-Based Asset Pricing Model," Journal of Finance, American Finance Association, vol. 56(5), pages 1837-1867, October.
  5. Acharya, Viral V & Pedersen, Lasse Heje, 2003. "Asset Pricing with Liquidity Risk," CEPR Discussion Papers 3749, C.E.P.R. Discussion Papers.
  6. Alejandro Justiniano & Northwestern University, 2006. "The Time Varying Volatility of Macroeconomic Fluctuations," Computing in Economics and Finance 2006 219, Society for Computational Economics.
  7. Schmitt-Grohe, Stephanie & Uribe, Martin, 2007. "Optimal simple and implementable monetary and fiscal rules," Journal of Monetary Economics, Elsevier, vol. 54(6), pages 1702-1725, September.
  8. Eisfeldt, Andrea L., 2007. "Smoothing with liquid and illiquid assets," Journal of Monetary Economics, Elsevier, vol. 54(6), pages 1572-1586, September.
  9. Frank Smets & Raf Wouters, 2007. "Shocks and Frictions in US Business Cycles : a Bayesian DSGE Approach," Working Paper Research 109, National Bank of Belgium.
  10. Phillippe Weil, 1997. "The Equity Premium Puzzle and the Risk-Free Rate Puzzle," Levine's Working Paper Archive 1833, David K. Levine.
  11. Canzoneri, Matthew B. & Cumby, Robert E. & Diba, Behzad T., 2007. "Euler equations and money market interest rates: A challenge for monetary policy models," Journal of Monetary Economics, Elsevier, vol. 54(7), pages 1863-1881, October.
  12. Jeffrey C. Fuhrer, 2000. "Habit Formation in Consumption and Its Implications for Monetary-Policy Models," American Economic Review, American Economic Association, vol. 90(3), pages 367-390, June.
  13. Andrew Atkeson & Patrick J. Kehoe, 2008. "On the Need for a New Approach to Analyzing Monetary Policy," NBER Working Papers 14260, National Bureau of Economic Research, Inc.
  14. Aiyagari, S. Rao & Gertler, Mark, 1991. "Asset returns with transactions costs and uninsured individual risk," Journal of Monetary Economics, Elsevier, vol. 27(3), pages 311-331, June.
  15. Jeffrey M. Lacker, 1997. "Clearing, settlement, and monetary policy," Working Paper 97-01, Federal Reserve Bank of Richmond.
  16. Bansal, Ravi & Coleman, Wilbur John, II, 1996. "A Monetary Explanation of the Equity Premium, Term Premium, and Risk-Free Rate Puzzles," Journal of Political Economy, University of Chicago Press, vol. 104(6), pages 1135-71, December.
  17. Marvin Goodfriend & Bennett T. McCallum, 2007. "Banking and Interest Rates in Monetary Policy Analysis: A Quantitative Exploration," NBER Working Papers 13207, National Bureau of Economic Research, Inc.
  18. Ricardo Lagos, 2006. "Asset prices and liquidity in an exchange economy," Staff Report 373, Federal Reserve Bank of Minneapolis.
  19. Stephanie Schmitt-Grohe & Martin Uribe, 2002. "Solving Dynamic General Equilibrium Models Using a Second-Order Approximation to the Policy Function," NBER Technical Working Papers 0282, National Bureau of Economic Research, Inc.
  20. Svensson, Lars E O, 1985. "Money and Asset Prices in a Cash-in-Advance Economy," Journal of Political Economy, University of Chicago Press, vol. 93(5), pages 919-44, October.
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