Transactions Cost and Interest Rate Rules

Hwagyun Kim () and Chetan Subramanian

Journal of Money, Credit and Banking, 2006, vol. 38, issue 4, 1077-1091

Abstract: This paper evaluates quantitatively the effect of real money balances in a New Keynesian framework. Money in our model facilitates transactions and is introduced through a transactions cost technology. This technology acts like a distortionary consumption tax which varies endogenously with the nominal interest rate. In this setup the resultant Phillips curve becomes a function of the nominal interest rate. Our analysis has important policy implications. First, we find, unlike Woodford (2003), accounting for real-balance effects does not result in the policy maker's loss function having an interest rate smoothing term. Second, we show that in the case of a temporary shock to productivity the optimal policy response under discretion is to allow for a trade-off between inflation and the output gap. This trade-off arises endogenously in our model. The quantitative effects on the macroeconomic variables are found to be significant.

Date: 2006
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Persistent link: https://EconPapers.repec.org/RePEc:mcb:jmoncb:v:38:y:2006:i:4:p:1077-1091

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