Edward Nelson

Edward Nelson
http://research.stlouisfed.org/wp/2008/2008-013.pdf   It is a short-run deviation from monetary neutrality, arising from the temporary nominal rigidities, that allows New Keynesian modelers to treat Rt as a policy instrument, and the Rt equation as a policy rule, in the equations describing variables’ dynamics. In the short run, with gradual price adjustment, open market operations are not met by a complete, instantaneous reaction of the price level. Consequently, these operations, on impact, not only affect nominal balances, but also real balances in the same direction. An enlargement of real money balances in turn produces an Rt fall—the liquidity effect—in order for the money demand equation to be satisfied; conversely, Rt rises in the case of a reduction in real balances. The monetary authority is able to affect both real and nominal interest rates via the liquidity effect produced by the change in real balances. In these circumstances, it is legitimate to follow the standard practice of studying dynamic systems which make Rt (or Rt relative to its steady-state value) the policy instrument, and then (assuming that the interest-rate rule features no reaction to money) the money demand equation assumes its familiar status of a redundant condition. But in the long run, things change: nominal price stickiness dissipates completely; monetary neutrality prevails; prices move by the same percentage as the nominal money stock; the determination of real money balances is separate from that of nominal balances; and the liquidity effect is gone.


WORLD LEADING ADVISORY SPECIALISING IN THIS TOPIC

GET NEWSLETTER

Sign up now to receive the latest blog posts and news about our research.