Liquidity effects and market frictions

Pricing-to-market, limited participation and exchange rate dynamics

“…Christiano et al (1997) yield the conclusion that any model with one type of friction (sticky prices or LP) cannot reproduce for the basic stylized facts of a money shock and stress the combined role of sticky prices and LP. A large number of papers confirm the potential of combining both type of frictions in a closed-economy setting (Hendry and Zhang, 2001;Papadopoulou, 2004 among others), which opens the route for such an analysis in an open-economy setting.…”

“…Furthermore, it displays improved results regards the relative volatility of both nominal and real exchange rates (relative to output). 34 A large number of papers confirm the potential role for combining both sticky-prices and LP in a closed-economy setting (Hendry and Zhang, 2001;Papadopoulou, 2004 among others). Our paper goes one-step further.…”

“…Credit market frictions are modeled by assuming LP of the representative household to the loanable funds market. Besides, we add portfolio adjustment costs as first developed by Christiano and Eichenbaum (1992) and commonly used in the related literature (see King and Watson, 1996;Hendry and Zhang, 2001;Ireland and Papadopoulou, 2004 among others). To understand the modeling of the LP assumption, it is useful to decompose the timing of the period in five steps.…”

“…Absent any reference value for the degree of adjustment costs on money holdings in the literature, we adopt the benchmark value x ¼ 1 as in Hendry and Zhang (2001). As common in the literature, we assess this value regards the corresponding cost of steady state leisure and in terms of minute per…”

“…The assumption of symmetry between countries implies that n ¼ 0:5 and o ¼ 0:5. We retain s ¼ 1:5 for the relative risk aversion degree, which is of same order as those usually retained in the literature (see Hendry and Zhang, 2001;Kollmann, 2001b) and close from the estimates of Barrionuevo (1991) for Japan, the United Kingdom and Germany. 16 As noted by Kollmann (2001b), the elasticity of substitution between domestic and foreign varieties ðyÞ is equal to the price elasticity of its import demand function (see Eq.…”