Inflation and Interest Rates with Endogenous Market Segmentation

Abstract

The authors examine a monetary economy where households incur fixed transactions costs when exchanging bonds and money and, as a result, carry money balances in excess of current spending to limit the frequency of such trades. As only a fraction of households choose to actively trade bonds and money at any given time, the market is endogenously segmented. Moreover, because households in this model economy have the ability to alter the timing of their trading activities, the extent of market segmentation varies over time in response to real and nominal shocks. The authors find that this added flexibility can substantially reinforce both sluggishness in aggregate price adjustment and the persistence of liquidity effects in real and nominal interest rates relative to that seen in models with exogenously segmented markets.

Keywords: Inflation, Interest rates