Modeling the response of money and interest rates to monetary policy shocks: a segmented markets approach

Abstract

This paper models the dynamic response of the nominal interest rate, the money growth rate and the real interest rate to monetary policy shocks. The monetary authority controls the supply of short-term government securities directly, and the short-term nominal interest rate indirectly through open market operations. It sets the nominal interest rate as an exogenous stochastic process, and lets the money growth rate and the real interest rate be determined endogenously. Markets are segmented in the sense that some households are permanently excluded from the market in government securities. The model is able to replicate the persistent decrease in the money growth rate and the persistent increase in the real interest rate which follow an unexpected increase in the nominal interest rate. The size and the persistence of the responses are close to those in the data. Markets segmentation decreases the volatility of the money growth rate, increases the volatility of the real interest rate, and increases the persistence of both processes.