Transactions Cost and Interest Rate Rules
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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.
Journal of money credit and banking
author list (cited authors)
Kim, H., & Subramanian, C.
complete list of authors
Kim, Hwagyun||Subramanian, Chetan