Persistent Liquidity Effects and Long-Run Money Demand

Abstract

We present a monetary model with segmented asset markets that implies a persistent fall in interest rates after a once-and-for-all increase in liquidity. The gradual propagation mechanism produced by our model is novel in the literature. We provide an analytical characterization of this mechanism, showing that the magnitude of the liquidity effect on impact, and its persistence, depend on the ratio of two parameters: the long-run interest rate elasticity of money demand and the intertemporal substitution elasticity. The model simultaneously explains the short-run “instability” of money demand estimates as well as the stability of long-run interest-elastic money demand. (JEL E13, E31, E41, E43, E52, E62)