DP1404 The Monetary Transmission Mechanism

Author(s): Jess Benhabib, Roger E A Farmer
Publication Date: May 1996
Keyword(s): Business Fluctuations, Indeterminacy, Sunspots
JEL(s): E00, E4
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=1404

In this paper we take as given that market economies are characterized by a set of stylized responses to increases in the stock of money. Innovations to the stock of money lead to increased output and reductions in short-term interest rates in the short run and only in the long run do nominal prices respond. These features of the monetary transmission mechanism have been discussed at least since David Hume. Most authors have attributed the real effects of money in the short run either to mistaken expectations or to non-market clearing or both. In this paper we argue that neither of these channels is needed to explain the facts. We show that a competitive market clearing model in which money enters the production function is fully capable of mimicking the broad features of the data. Our argument relies on an explanation of ?price stickiness? that exploits a multiplicity of equilibria in a rational expectations model.