Liquidity Effects and Transactions Technologies

Dotsey, Michael, Ireland, Peter, Kydland, Finn E., Schlagenhauf, Don, Wrase, Jeffrey, Journal of Money, Credit & Banking

Recently there has been growing interest in using general equilibrium models to understand the effects of monetary policy on interest rates and real economic activity. This research effort has involved the search for models that will account for the liquidity effects--the decrease in short-term interest rates and the increase in output and employment--that are associated with expansionary monetary policy. Empirically, liquidity effects have been isolated by Cochrane (1989), Christiano and Eichenbaum (1991b), Strongin (1992), and Gordon and Leeper (1993). More informally, financial market participants usually interpret Federal Reserve-engineered rises in short-term nominal interest rates as a tightening of monetary policy.

The theoretical impetus for this literature is found in Lucas (1990). No two papers use the exact same specification, but a common feature of the literature is the presence of cash-in-advance (CIA) constraints that limit the amount of money available for use in loan or securities markets.(1) Each change in specification involves various assumptions about financial structure that place infinite transactions costs on flows of funds across segmented markets. Most frequently, the differences in specification are motivated by the emphasis of the particular model: whether it is primarily concerned with asset pricing or with generating business cycles.

In fact, the assumption of infinite transactions costs across markets is most reasonable when applied to understanding the behavior of asset prices on a daily or weekly basis. To study the effects of monetary policy at business cycle frequencies, however, assumptions of infinite transactions costs are less innocuous. In this paper we consider the effects of relaxing these extreme assumptions in the monetary business cycle model of Christiano and Eichenbaum (1991b).(2) We do this by generalizing their CIA constraints, allowing agents to rearrange their portfolios at a finite cost after observing the monetary disturbance. Given the quarterly periodicity of the model, it seems realistic that agents have access to such a transactions technology. Our ultimate goal is to study the interaction between the magnitude of the transactions costs and the presence of liquidity effects on a quarterly basis.

The CIA constraints in Christiano and Eichenbaum's model give rise to one of the model's principal implications, that "a disproportionately large share of monetary injections is absorbed by firms to finance variable inputs" (Christiano and Eichenbaum 1992, p. 352). In the absence of detailed flow-of-funds data with which to test this implication, our generalized version of the Christiano-eichenbaum model illuminates an alternative, but closely related, implication. Specifically, our transactions technology gives rise to a spread between loan and deposit rates that varies systematically with the size of the monetary shock. In essence, our framework reveals that prices (that is, interest rates) rather than quantities (that is, flows of funds) can be used to assess the empirical relevance of the Christiano-eichenbaum model. In fact, we find that specifications for transactions costs that allow the model to match the behavior of key interest rate spreads either remove or greatly dampen the liquidity effects that are present in Christiano and Eichenbaum's original work.

The next section briefly reviews Christiano and Eichenbaum's model. Section 2 generalizes this model, as suggested above, by allowing agents more flexibility to adjust their financial portfolios in response to monetary disturbances. Section 3 describes the solution and parameterization of our generalized model, while section 4 presents the results and section 5 concludes.

1. THE CHRISTIANO-EICHENBAUM MODEL

Here we briefly sketch out the main features of the Christiano and Eichenbaum model. Each period is broken into two parts-the justification being that production requires a sustained flow of labor input and that open market operations occur in the midst of ongoing productive activity. The division of the period into two parts is a tractable way of representing such an environment.

During the first part of the period, following the realization of the technology shock but prior to the realization of the monetary shock, households allocate their portfolios between a transactions medium and the liability of a financial intermediary. They also decide on their first-part-of-period labor effort. To finance their wage bill, firms decide how much to borrow from intermediaries at a first-part-of-period nominal interest rate. They also decide how much to invest. In this model, payments to labor are subject to a cash-in-advance constraint while investment is a credit good.

In the middle of the period, a monetary disturbance occurs in the form of a lumpsum transfer to intermediaries. Households and firms then make their second-part-of-period labor decisions, with firms borrowing their wage payments from intermediaries at a second-part-of-period interest rate. Households make their consumption decisions subject to a cash-in-advance constraint that involves not only their initial holdings of the medium of exchange but their current period wage receipts as well. The liquidity effect arises because the lump sum transfer affects the quantity of loanable funds. It is augmented by the fact that certain production decisions, namely, initial labor hours, are state variables from the perspective of second-part-of-period decisions. A more formal description of the economic environment follows.

a. The Firm's Problem

The firm's problem is to maximize

[Mathematical Expression Omitted]

where [F.sub.t] is the flow of nominal profits, [u.sub.c,t+1] is the representative agent's marginal utility of consumption at time t + 1, [P.sub.t+1] is the price level at time t + 1, and the information set [Mathematical Expression Omitted] includes all variables and disturbances dated t - 1 and earlier as well as the first-part-of-period wage rate [W.sub.t], the first-part-of-period loan rate [R.sub.t], the capital stock [K.sub.t+1], the technology shock …

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Publication information: Article title: Liquidity Effects and Transactions Technologies. Contributors: Dotsey, Michael - Author, Ireland, Peter - Author, Kydland, Finn E. - Author, Schlagenhauf, Don - Author, Wrase, Jeffrey - Author. Journal title: Journal of Money, Credit & Banking. Volume: 27. Issue: 4 Publication date: November 1995. Page number: 1441+. © 1999 Ohio State University Press. COPYRIGHT 1995 Gale Group.

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