Transactions Cost and Interest Rate Rules Academic Article uri icon


  • This paper evaluates quantitatively the effect of real money balances in a New Keynesian framework. Money in our model facilitates transactions and is introduced through a transactions cost technology. This technology acts like a distortionary consumption tax which varies endogenously with the nominal interest rate. In this setup the resultant Phillips curve becomes a function of the nominal interest rate. Our analysis has important policy implications. First, we find, unlike Woodford (2003), accounting for real-balance effects does not result in the policy maker's loss function having an interest rate smoothing term. Second, we show that in the case of a temporary shock to productivity the optimal policy response under discretion is to allow for a trade-off between inflation and the output gap. This trade-off arises endogenously in our model. The quantitative effects on the macroeconomic variables are found to be significant. Copyright 2006 by The Ohio State University.

published proceedings

  • Journal of money credit and banking

author list (cited authors)

  • Kim, H., & Subramanian, C.

citation count

  • 4

complete list of authors

  • Kim, Hwagyun||Subramanian, Chetan

publication date

  • June 2006