QUEST II. A Multi-Country Business Cycle and Growth Model

Also, thevarious assets(shortandlongtermprivateandgovernmentbonds)indomestic
financialmarketsareperfectlysubstitutable.Weassumethatthereisnomoneyillusionin
financialmarkets,implyingthattheFisherequationholds

L = и, + (, ∆3,+1/ 3

(33)

wherei_tandr_tarethenominalandrealoneperiod interest rates respectively. Bonds of
longermaturityarelinkedtoexpectedshortratesviaatermstructurerelationship.

Lr = Li ⁺ ( ^δLtl / L

(34)

Moneydemandismodelledviaaconventionalmoneydemandequationwhichstressesboth
transactionandspeculativemotivesofmoneyholding

0, / 3 =( < (1 + L )ʃ')( 0 -,/ 3-, )"

(35)

The modelcanbesimulatedunderalternativemonetarypolicyassumptions.Instandard
settingitisassumedthatthemonetaryauthoritiesadheretoaregimeofmonetarytargeting,
whileinanalternativesettinginterestratetargetingcanbeassumed.Themodelcontains
thefollowinginterestratepolicyreactionfunction

L_f = L,-, ⁺ P, ^llog(07 /M, ) ⁺ P2 log(³ /3-, )

(36)

where MT is the money target, E the interest elasticity of money demand and P₁ a switch
variablewhichtakesalargevalueundermoneytargetingandasmallvalueunderinterest
ratetargeting.Inthefirstcaseinterestratesaresetsoastoassurethemoneytargetismet
almostinstantaneously,whileinthelattercaseinterestratesarekeptalmostconstantinthe
shortrunandmoveonlygraduallytowardsthelongrunlevelconsistent with money
demandandthesupplytarget.Thesetwoextremesettingsallowustosimulatescenarios
that come close to constant money supplies and constant interest rates 4. With P₂ positive
and P₁ close to zero the above interest rate rule approximates inflation targeting. In order
tosimulateEMUtypescenarios,theaboveinterestratereactionfunctionhas also been
addedforanEUaggregate.InsuchscenariosaEuropeancentralbanktargetsanaggregate
EUmoneytargetorinterestrate.

⁴Obviously,interestratescannotbepermanentlykeptconstantasthatwouldleadtopricelevel
indeterminacy

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