Description
Abstract: Two problems exist in standard limited-participation models: (1) the liquidity effect is not as persistent as in the data; and (2) some nominal variables are unrealistically volatile. To address these problems, we introduce nominal wage, price, and portfolio adjustment costs, to better understand how each cost affects the size and length of the liquidity effect and the volatility of inflation following a central-bank policy action. Quantitative analysis shows that each of the adjustment costs has a very different effect on the nominal interest rate, inflation and output. The impulse response functions are more realistic in the case with all three adjustment costs than with any other combination.