Thursday, 23 March 2017: 16:50
This paper evaluates the implications of search and matching frictions in the financial market for the transmission of monetary policy. Borrowers and lenders participate in a decentralized loan market for the purpose of establishing long-term credit relationships and the provision of loanable funds to productive firms. Locating credit relationships is costly in terms of time and real resources, and the interest rate is negotiated via a bargaining mechanism. This structure is incorporated into an otherwise standard monetary business cycle framework, and used to study how such frictions in the credit market contribute to explaining the contemporaneous impact and propagation of monetary growth shocks and inflation. In particular, households must finance consumption purchases with money balances net of the funds that are either tied to existing credit relationships, or used in the search of new relationships. The monetary authority also participates in the decentralized financial market by making additional cash transfers available as loanable funds. Having these funds available after the household chooses its deposit decision provides the limited participation mechanism, where monetary transfers lead to a lower nominal interest rate. We find that while anticipated inflation negatively impacts real activity, it can also increase loan market participation and form newly established credit relationships. It is shown that while bargaining and costly search mitigates the traditional inflation tax effect of monetary injections, the existence of long term lending relations tends to dampen the immediate liquidity effects. We also find that there may not exist a negative correlation between credit market tightness and aggregate activity. Furthermore, search frictions provide a potentially important mechanism for explaining the persistence of monetary shocks, an issue that has been problematic in limited participation models of the transmission mechanism.