We develop an equilibrium model of the monetary policy transmission mechanism that highlights information frictions in the market for money and search frictions in the market for labour.

A change in monetary policy regime, modelled here as an exogenous reduction in the long-run target for the money-growth rate, results in a large and persistent increase in the interest rate owing to a persistent shortfall in liquidity. This persistent liquidity effect occurs because of the limited information that individuals have concerning the nature of the shock, which implies that individuals optimally update their inflation forecasts using an adaptive expectations rule. The subsequent period of high interest rates curtails job-creation activities in the business sector, making it more difficult for the unemployed to find suitable job matches; employment bottoms out two to three quarters after the shock. In the long run, however, employment rises above its initial level, primarily because of the lower long-run interest rates associated with a tight-money regime.

Published In:

Canadian Journal of Economics (0008-4085)
May 2004. Vol. 37, Iss. 2, pp. 392-420