There is a growing awareness that monetary policy is not super-neutral in many countries. In particular, in high inflation economies, a significant amount of evidence indicates that inflation is negatively related to economic activity. For example, in their study of Argentina and Brazil, Bae and Ratti (2000) find that higher rates of money growth are associated with lower levels of output. By comparison, inflation may be positively correlated with output in low inflation economies. Notably, Bullard and Keating (1995) demonstrate that inflation is positively correlated with output in some low inflation countries while in others there is no relationship. Ahmed and Rogers (2000) focus on the U.S. economy. In their analysis, inflation and output are positively correlated. It has also been observed that inflation is generally higher in developing countries than industrialized economies.
Why do the effects of monetary policy vary across countries? In this paper, we propose an interesting explanation based on the degree of liquidity risk at different stages of economic development. In particular, in poor countries, individuals are more susceptible to events which cause them to liquidate their holdings of assets. This behavior is well documented in a number of studies of developing countries. Since the exposure to liquidity risk varies across countries, individuals respond differently to rates of return in low income countries than in advanced economies. As a result, the effects of monetary policy will also vary between developing and advanced countries.
We proceed by outlining the details of our modeling framework. We study an overlapping generations economy with production similar to Diamond (1965). Following Townsend (1987) and Schreft and Smith (1997), there are two different geographically separated locations. There are also two types of assets: fiat money and physical capital. Within each location, agents have complete information regarding others’ asset holdings. However, across locations, there is incomplete information such that individuals do not have the ability to establish and trade claims to assets. If an individual is forced to trade outside of his location of residence, he must acquire money balances. In this manner, private information leads to a transactions role for money.
Furthermore, individuals are subject to random relocation shocks. As money is the only asset that can cross locations, relocated agents must liquidate all their asset holdings into currency. Thus, random relocation is analogous to liquidity preference shocks in Diamond and Dybvig (1983). As a result, the model illustrates the risk pooling role of financial intermediaries.
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Liquidity Risk, Economic Development, and the Effects of Monetary Policy
