Also, thevarious assets(shortandlongtermprivateandgovernmentbonds)indomestic
financialmarketsareperfectlysubstitutable.Weassumethatthereisnomoneyillusionin
financialmarkets,implyingthattheFisherequationholds
L = и, + (, ∆3,+1/ 3
(33)
whereitandrtarethenominalandrealoneperiod 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
Lf = 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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