Breaking the New Keynesian Dichotomy: Asset Market Segmentation and the Monetary Transmission Mechanism

We develop a general framework to examine how the presence of a monetary transmission mechanism shapes aggregate responses to shocks and the effects of monetary policy. Our framework nests two leading monetary models: a text-book New Keynesian setting and a setting where small transactions costs associated with adjustments in households’ money balances lead to an evolving distribution of money across households. In the text-book New Keynesian model, the effective isolation of a single condition determining aggregate money demand imposes a dichotomy that eliminates any role played by the demand for money in the determination of aggregate demand whenever the monetary authority uses an interest rate rule. As such, it rationalizes a narrow attention to direct links between interest rate setting and objectives such as desired paths for inflation and real activity in a wide range of current discussions involving monetary policy. In this paper, we argue that the simplicity of the Keynesian dichotomy is not an inevitable or desirable feature of a tractable monetary model. The basic mechanism implying non-neutralities in our second nested model does not permit the dichotomy raised above. Rather, households’ decisions regarding consumption and labor supply in this model are intimately affected by both their individual money holdings and, through wages and interest rates, the entire distribution of money balances. This implies a rich monetary transmission mechanism, in that the level of aggregate demand depends crucially on monetary factors. Examining a composite setting where the pricing frictions of New Keynesian monetary models are allowed to interact with the rich money demand mechanism implied by households’ inventory-theoretic portfolio management, we find that the resulting model is not only tractable, but also has very desirable properties from an empirical standpoint. When solved under a money stock rule, it implies a path for the nominal interest rate that initially declines in the face of a monetary expansion, in keeping with the liquidity effect documented across a broad range of empirical studies. Moreover, when solved under a standard interest rate rule, our model implies greater persistence in the dynamic responses following shocks to monetary policy, as well as nonmonotone responses to real shocks. These desirable implications emerge precisely because it is not possible to describe aggregate demand without reference to money demand in our model. The distribution of transactions balances across individuals is an essential part of the transmission mechanism from monetary policy actions to real economic activity.