Persistent Liquidity Effects Following a Change in Monetary Policy Regime

We develop an equilibrium model of the monetary transmission mechanism that highlights search frictions in the market for labour and information frictions in the market for money. A change in monetary policy regime, modelled here as an exogenous reduction in the 'long-run' money growth rate target, results in a large and persistent increase in the interest rate owing to a persistent shortfall in liquidity. This persistent 'liquidity effect' arises because of the limited information that individuals have concerning the nature of the shock, which implies that individuals optimally update their inflation forecasts using an 'adaptive' expectations rule. The subsequent period of high interest rates curtails job creation activities in the business sector, making it more difficult for the unemployed to find suitable job matches; employment bottoms out two to three quarters following the shock. In the long run, however, employment rises above its initial level, primarily because of the lower long-run interest rates associated with a tight-money regime.