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Liquidity Risk, Economic Development, and the Effects of Monetary Policy

  • Edgar A. Ghossoub

    (The University of Texas at San Antonio)

  • Robert Reed

    (University of Alabama Tuscaloosa)

Empirical evidence indicates that monetary policy is not super-neutral in many countries. In particular, in high in?ation economies, in?ation is negatively related to economic activity. By comparison, in?ation may be positively correlated with output in low in?ation countries. We present a neoclassical growth model with money in which the incidence of liquid- ity risk is inversely related to aggregate capital formation. Interestingly, there may be multiple monetary steady-states where the e¤ects of mon- etary policy vary. In poor economies, the ?nancial system is highly dis- torted and higher rates of money growth are associated with less capital formation. In contrast, in advanced economies, a Tobin e¤ect is observed. Since in?ation exacerbates distortions from a coordination failure in the low capital steady-state, individuals become much more exposed to liq- uidity risk. Consequently, optimal monetary policy depends on the level of development.

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Paper provided by College of Business, University of Texas at San Antonio in its series Working Papers with number 0070.

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Length: 30 pages
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Handle: RePEc:tsa:wpaper:0070
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