What is the liquidity effect and how to model it are two frequently debated questions among monetary economists, that have received extensive attention in recent years. Evidence based on a structural VAR shows that when the Fed surprises financial markets by suddenly decreasing the rate of money growth through an open market sale, the nominal interest rate rises on impact, in company with a drop in aggregate employment and output. Prices, however, are affected gradually. This is the so called liquidity effect. Therefore, any plausible model of monetary policy should account for this behavior. Several competing monetary models currently exist with each employing a different transmission mechanism of monetary policy.
Two of the most popular transmission mechanisms of monetary shocks in the recent literature are price stickiness and financial market frictions. In a sticky price environment, such as Kydland (1989) and Christiano (1997), monopolistically competitive producers are unable to immediately adjust prices in response to a monetary shock. Those models attempt to explain the responses of aggregate output and prices, but fail to generate observed variability in the nominal interest rates following a monetary policy shock. On the other hand, in a limited participation environment, for instance Lucas (1990) and Fuerst (1992), money plays a role in the economy due to its asymmetric distribution among economic agents. Those models, in contrast to sticky price models, give rise to a small liquidity effect, but have difficulty in producing the appropriate effects on output and prices. Moreover, the liquidity effect in those models exhibits no persistence and only exists in the impact period of the policy action. To reproduce the desired liquidity effect, several remedies have been proposed, one of which (Christiano, Eichenbaum and Evans (CEE) 1997) suggests that embedding labor market frictions into either type of model might help generate the liquidity effect and prolong the impact of monetary shocks.
In fact, adding labor market search into a DGE model is not entirely new in the literature. Merz (1995), Andolfatto (1996) and Hairault (2002) show that labor market search improves the ability of real business cycle models to match important macro data. However, importing a labor search friction into the monetary field is a quite new practice. Shi (2004) constructs a dynamic equilibrium model with both labor market and goods market search to examine the model’s quantitative predictions for aggregate variables and, in particular, on the variability of the velocity of money in response to money growth shocks. Walsh (2005) incorporates both labor market search and sticky prices in order to explore the dynamic response of the economy to nominal interest rate shocks. However, in the previous literature, to introduce the liquidity effect, firms must borrow cash in advance from financial intermediaries to pay the wage bill, which is a very controversial assumption. Keen (2004) argues that it seems more plausible to finance labor costs internally since labor is a flow variable. Williamson (2005) points out that, in the United States, few workers are paid in cash and therefore, it seems difficult to argue that firms subject to cash-in-advance constraints account for a significant fraction of U.S. employment.
This paper contributes to the literature by examining the responses of the economy to a monetary policy shock in a dynamic general equilibrium model in the presence of frictions in both financial markets and labor markets, serving as a transmission and amplifying mechanism from monetary policy to the real side of the economy. The whole investigation is done in a context of flexible prices. Rather than having firms purchase labor directly subject to a cash-in-advance constraint, I relax this assumption and assume employment can be financed with current sales receipts. However, in this model, firms will face a cash constraint in purchasing recruitment and vacancy creating services from other households. This embellishment makes the model seem more plausible.
In this paper, the frictions of limited participation capture the financial disconnectedness in the economy. The central bank implements monetary policy by conducting open market operations in the asset market, which exerts heterogeneous impacts on the agents. Consumers’ decisions are made and locked in prior to the disclosure of the monetary policy shock. Thus, monetary shocks will initially involve the financial sector and firms only. Under this circumstance, financial institutions and firms have to face and absorb a disproportionate share of changes in the money supply, which creates variability in the nominal interest rate and job vacancy creation. For instance, a contractionary open market operation would reduce the liquidity available in the economy and tighten the cash-in-advance constraint facing firms. Then, the bond price (or the nominal interest rate) is pushed down (up) and fewer vacancies are posted. Employment and output will be scaled back accordingly. The liquidity effect is, therefore, generated by the frictions of limited participation in financial markets.
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