Breaking the New Keynesian Dichotomy: Asset Market Segmentation and the Monetary Transmission Mechanism

Julia Thomas and Robert G. King
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Robert G. King: Boston University and NBER

No 883, 2007 Meeting Papers from Society for Economic Dynamics

Abstract: When we examine a composite setting where the firm-side sluggish price adjustment central throughout New Keynesian monetary analysis is allowed to interact with the rich money demand mechanism implied by household-side inventory-theoretic portfolio management, we find that the resulting model is not only tractable, but also has very desirable properties from an empirical standpoint. For example, when it is solved under a money stock rule, it implies a path for the nominal interest rate that initially declines in the face of a monetary expansion and returns only gradually returns to its steady-state value, in keeping with the liquidity effect documented across a broad range of empirical studies. By contrast, in the standard New Keynesian model, the same shock inevitably raises the nominal rate. Moreover, when our composite model is solved under a standard interest rate rule, there are much more protracted dynamic responses following shocks to monetary policy, as well as nonmonotone responses to real shocks. These desirable implications from our model come precisely because it is not possible to describe aggregate demand without reference to money demand; the distribution of transactions balances across individuals is an essential part of the transmission mechanism from monetary policy actions to real economic activity.

Date: 2007
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