In recent years a large number of studies have used the identified-VAR methodology to assess the effects of monetary shocks. This literature documents that contractionary monetary shocks have a persistent negative effect on output and employment, and a persistent positive effect on interest rates. For example, Christiano, Eichenbaum, and Evans (1999) review a number of different approaches for identifying monetary shocks, and find that interest rates rise for at least six month after a contractionary monetary shock, whereas the negative effect on out put lasts for well over a year. These conclusions are robust across most identification schemes for monetary shocks used in the literature.
Explaining these findings is a challenge for economic theory. Frictionless models do not generate any real effects of monetary disturbances. In the recent theoretical literature there are two main classes of models which generate real effects of monetary shocks, the “liquidity” model and the “sticky-price” model (see Cole and Ohanian 2002 for a recent comparison of the two frameworks). Even though both models give rise to real effects of monetary shocks, they have trouble generating persistence. In the “liquidity” or “limited participation” model, households are unable to adjust their asset holdings immediately when a monetary shock hits (see Lucas Jr. 1990 and Christiano and Eichenbaum 1992).
Firms and banks can react to monetary disturbances at once, whereas households react only with a delay of one period. The liquidity model generates real effects of monetary shocks. However, the effects are short-lived. Once households are able to adjust their asset position in the period following the shock, all real effects disappear. The friction at the heart of the “sticky price” model are nominal rigidities generated by staggered price-setting (see Taylor 1980 and Blanchard 1991). While in a sticky-price model real effects can last longer than one period, Chari, Kehoe, and McGrattan (2000) show that in a calibrated model with staggered price setting there is very little persistence unless the frequency of price adjustments is assumed to be unrealistically low.
This paper explores whether a model with a different friction, namely small adjustment costs for household asset transactions, can account for persistent effects of monetary shocks. I develop an otherwise standard cash-in-advance model in which households have checking and saving accounts and face a small adjustment cost for transfers between their accounts. This cost can be interpreted as banking fees, as well as the opportunity cost of the time which is used for carrying out the transactions (the “shoe-leather” cost of the Baumol-Tobin model). Notice that this setup is very similar to the liquidity model in spirit. In particular, the liquidity model can be interpreted as an adjustment-cost model where the cost for immediate transactions is infinite, but the cost for scheduled future transactions is zero.
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Show Me the Money: Retained Earnings and the Real Effects of Monetary Shocks
