Monetary Shocks and Bank Intermediation in a Dynamic Stochastic General Equilibrium Model

Abstract

Empirical studies have shown that in economies with relatively low inflation rates output growth and money growth are correlated (McCandless & Weber 1995). The purpose of this study is to illustrate how the basic Real Business Cycle (RBC) model can be modified to incorporate money in an attempt to construct monetary business cycle model such that the dynamics of the model also give positive correlation between money shocks and output. This is meaningful since understanding how monetary shocks generate real effects is critical for any normative analysis of monetary policy. It is conjectured that the banking sector plays an important role in the monetary transmission mechanism and money is injected into the model through financial intermediaries. It is observed in this model that a positive monetary shock reduces interest rates and stimulates economic activity, which is called the liquidity effect. Furthermore, the statistics generated by the model shows that monetary shocks have significant real impact when money enters through the financial system. Taken together, this implies that how money enters into the model significantly matters for the impact of monetary shocks and such shocks entering through financial intermediaries may be important in determining the cyclical fluctuations of the U.S. economy.

Keywords: Business cycle, money growth shock, monetary transmission mechanism, financial intermediaries, liquidity effect