Firms' Money Demand And Monetary Policy

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Executive Summary

Standard New Keynesian models for monetary policy analysis are "Cashless". When the nominal interest rate is the central bank's operating instrument, the LM equation is endogenous and, it is argued, can be ignored. The modern theoretical and quantitative debate on the importance of money for the conduct of monetary policy, however, overlooks firms' money demand. Working in an otherwise baseline New Keynesian setup, this paper shows that the monetary policy transmission mechanism is critically affected by the firms' money demand choice. Specifically, the authors prove that equilibrium determinacy may require either an active interest-rate policy (i.e., overreacting to inflation) or a passive interest-rate policy depending on the elasticity of production with respect to real money balances.

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