Credit Markets and the Propagation of Monetary Policy Shocks



on, all variables and distributions will converge to the stationary equilibrium as-
sociated with the new monetary policy. To solve for this transition, we have to
work with the sequence of values of normalized prices p
t , real wages wt and interest
rates R
t that satisfy the conditions (7) and (8) together with the evolution of the
distribution of assets. Once the sequence of p
t is computed, we can calculate the
sequence of prices from

Pt = ptXt .

These computations cannot be carried out analytically. We perform them in the
following numerical exercise.

This basic mechanism just described resembles the one used in the limited
participation literature. In this literature, nonneutrality of money is achieved by
imposing two assumptions: (i) the nominal interest rate represents a cost to firms,
and (ii) households providing funds to firms cannot react to changes in monetary
policy. Thus, an injection of money by the central bank means that entrepreneurs
have also to absorb a larger amount of liquidity which forces interest rates to de-
crease and have the same expansionary effects on economic activity. Because loans
to entrepreneurs are the only asset on the balance sheet of commercial banks, con-
dition (ii) is needed in these models so that households cannot undo the monetary
policy change. As compared with the limited participation literature, we substi-
tute condition (ii) by imposing a reserve requirement together with the existence
of government debt. In our model, the fractional reserve requirement links the
amount of liquidity in the economy to the supply of reserves while borrowing by
the government determines which part of that liquidity has to be absorbed by
entrepreneurs.

4 simulations

For the simulations we use a logaritmic utility and a Cobb-Douglas production
function. Periods are assumed to be quarters. Table 2 includes the value of the
main parameters of the model. As we see by the value of θ, there exists decreasing
returns to entrepreneurs’ projects. These values are standard in the literature. The
reserve requirement ρ is 3 percent in the Unites States. The parameters related to
the distribution of ability shocks (Z) and transition matrices for them are included
in Table 3.

Table 4 reports the values of some key variables for the initial steady state
(column SS1). We start with a value of h which implies a ratio of liquid to illiquid
liabilities of h/b = 0.10. The economy rests in an equilibrium where the capital to
output ratio is 9.61. Furthermore, 12 percent of the population are entrepreneurs
and 88 percent workers. Of all entrepreneurs, 23 percent are constrained in their

21



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