Long and Plosser meet Bewley and Lucas

Abstract

We develop an N-sector business cycle network model a la Long and Plosser (1983), featuring heterogenous money demand a la Bewley (1980) and Lucas (1980). Despite incomplete markets and a well-defined distribution of real money balances across heterogeneous households, the Bewley–Lucas–Long–Plosser model remains analytically tractable with closed-form solutions. Relying on the tractability, we establish several important results: (i) The economy’s input-output network linkages become endogenously time varying over the business cycle—thanks to the endogenous time-varying distribution of money demand and its influence on cross-sector allocations of commodities. (ii) Despite flexible prices, transitory money injections can generate highly persistent effects on sectoral output, also thanks to the time-varying distribution of money demand and its effect on input-output coefficients. (iii) Although money injection is distributed equally across households by design, the real effects are asymmetric across production sectors; e.g., the impact of money is strongest on downstream sectors that purchase intermediate goods from the rest of the economy, but weakest on upstream sectors that supply intermediate goods to the other sectors, in sharp contrast to the case of sectoral technology shocks and government spending shocks. Our model also provides a micro-foundation for the labor wedge and shows that movements in the distribution of money demand can explain the cyclical behavior of the labor wedge.