Elastic Money, Settlement, and Interest Rate Policy

Junfeng Qiu () and Allen Head ()

No 872, 2007 Meeting Papers from Society for Economic Dynamics

Abstract: The transmission of monetary policy is studied in an environment in which aggregate liquidity shocks affect agents asymmetrically. Agents are subject to random liquidity requirements and interact with banks which both take deposits and make loans. Banks may issue loans in excess of their deposits but face liquidity constraints due to settlement requirements which are satisfied using fiat money created by the central bank. The total money supply is determined endogenously by credit transactions. Changes in the overall money stock have different implications for prices and inflation depending on whether they are associated with growth in the supply of central bank issued (outside) money or with money creation by private banks (inside money). By affecting the price level, changes in the quantity of inside money redistribute wealth. The central bank can control the interest rate and may improve welfare by adjusting it in response to aggregate shocks in order to mitigate the effects of price level increases on agents who have access only to their monetary savings. The effectiveness of this interest rate policy depends on the average inflation rate-in particular the policy becomes ineffective when the nominal interest rate is sufficiently low.

Date: 2007
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Persistent link: https://EconPapers.repec.org/RePEc:red:sed007:872

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