A Transactions Based Model of the Monetary Transmission Mechanism: Part 2

In Part 1 the dynamics of an open market operation were analyzed for the case of logarithmic utility. Though such a utility function is useful for illustrative purposes, the implication that current prices are independent of current and future monetary injections is unsatisfactory. This implication results from the fact that with logarithmic utility future consumption is independent of the rate of return to savings. In Part 2 the logarithmic utility assumption is replaced by the more general assumption that utility is of the constant elasticity form such that future consumption is an increasing function of the interest rate. Though a closed form solution cannot be derived for this case, it is shown that the basic results of Part 1 still hold: An increase in money causes a sluggish response of the price level and a fall in interest rates.