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

Edgar Ghossoub and Robert Reed
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Edgar Ghossoub: The University of Texas at San Antonio
Robert Reed: University of Alabama Tuscaloosa

No 70, Working Papers from College of Business, University of Texas at San Antonio

Abstract: 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.

Keywords: Economic Development; Banks; Monetary Policy (search for similar items in EconPapers)
JEL-codes: E31 E41 E52 O42 (search for similar items in EconPapers)
Pages: 30 pages
Date: 2008-08-19
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