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CAPACITY AND ASYMMETRIES IN MONETARY POLICY

it considers portfolio constraints that create a short run non-neutrality of mone-
tary policy. Regarding the first component, the model presented here follows the
formulation of Fagnart, Licandro and Portier (1999) in modelling the issue of ca-
pacity utilization.3 These authors introduce idiosyncratic demand uncertainty and
a rich modeling of the production sector (firms heterogeneity and absence of an
aggregate production function) within a monopolistic competitive business cycle
model. The bulk of their model relies on three basic aspects: first, the limited
possibilities of a short run substitutability between production factors; second, the
presence of uncertainty at the time of capacity choices, which explains the presence
of underutilized equipments; and third, the existence of idiosyncratic uncertainty
which results in a nondegenerate distribution of utilization rates across firms. In
equilibrium, a proportion of firms face demand shortages and have idle capacities,
while others are at full capacity and are unable to serve any extra demand. More-
over, the monopolistic competitive environment provides an additional source of
dynamics through optimal mark-up changes.

Regarding the second ingredient of the model, namely the monetary side, this
paper considers the existence of participation constraints in the financial market,
which create non-neutralities of monetary policy. Specifically, the effects of an
unexpected monetary policy action are firstly felt through the demand for money
and the short term interest rate -the
liquidity effect- which subsequently affects
investment and output, known this as
output effect. The magnitude and persistence
of such effects are clearly an important issue, as they capture a key nonneutral
effect of monetary policy. Explaining the strong relationship between money and
real activity in a general equilibrium theory involves facing two challenges. The
first is to provide a theory in which money is valued in equilibrium. This is done
assuming a cash-in-advance constraint. Secondly, and more difficult, it is to show
how monetary policy has real effects in a world where economic agents are behaving
rationally, without simply assuming some
ad hoc form of money illusion. The
limited participation paradigm provides a rationale for this issue.4 The basic idea
is that money plays a role in the economy due to its asymmetric distribution to
economic agents: money is firstly distributed to financial intermediaries an then to
firms before it finally reaches consumers’ hands.®

Two features describe the mechanism working in these models (i) changes in the
money supply initially involve the monetary authority and financial sector only and
(ii) the representative household’s supply of funds, through bank deposits, is prede-
termined relative to monetary shocks. Under these circumstances, an unanticipated
money injection increases the share of liquid assets held by financial intermediaries.
Thus, firms are forced to absorb the excess Ofliquidity in the economy. The market
clearing interest rate falls as a result. The liquidity effect can generate a strong real
response to monetary policy by changing the financial costs of hiring factors of pro-
duction. The existence of production inflexibilities that arise due to the existence
of capacity utilization constraints will condition the intensity of the liquidity and

3Probably, the first attempt to rationalize explicitly equipment idleness in a real business cycle
model is due to Cooley, Hansen and Prescott (1995).

4A second strand of the literature, known as the new neoclassical synthesis -see Goodfriend
and King (1997)- highlights the role of nominal frictions in shaping key features of monetary
economies.

8Basic references in the literature on limited participation models include Lucas (1990), Fuerst
(1992) and Christiano (1991).



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