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Liquidity Effects and Market Frictions

Scott Hendry () and Guang-Jia Zhang

Staff Working Papers from Bank of Canada

Abstract: The goal of this paper is to shed light on the nature of the monetary transmission mechanism. Specifically, we attempt to tackle two problems in standard limited-participation models: (1) the interest rate liquidity effect is not as persistent as in the data; and (2) some nominal variables are unrealistically volatile. To address these problems, we introduce nominal wage and price rigidities, as well as portfolio adjustment costs and monopolistically competitive firms, to better understand how each of these costs affects the size and length of the liquidity effect following a central-bank policy action. Quantitative analysis shows that including these rigidities does improve the model, to some extent at least, in the expected manner. The main findings are: (1) wage and portfolio adjustment costs are able to deepen and lengthen the liquidity effect following a monetary policy action; (2) these two adjustment costs, especially wage adjustment costs, can reduce inflation volatility; (3) price adjustment costs, at least under money-growth policy rules, cause excessive interest-rate volatility and are unable to significantly reduce inflation volatility.

Keywords: Transmission; of; monetary; policy (search for similar items in EconPapers)
JEL-codes: E5 (search for similar items in EconPapers)
Pages: 53 pages
Date: 1998
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Related works:
Journal Article: Liquidity Effects and Market Frictions (2001) Downloads
Working Paper: Liquidity Effects and Market Frictions (1999) Downloads
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Persistent link: https://EconPapers.repec.org/RePEc:bca:bocawp:98-11

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