How well does a limited participation model of the monetary transmission mechanism match UK data?

Working papers set out research in progress by our staff, with the aim of encouraging comments and debate.
Published on 26 June 2000

Working Paper no. 118
By Shamik Dhar and Stephen P Millard

In this paper we determine how well a ‘limited participation’ model of the monetary transmission mechanism is able to match important aspects of the UK economy. Such models were developed initially by Lucas (1990), Fuerst (1992) and Christiano and Eichenbaum (1992, 1995), but our version (described in detail in Dhar and Millard (2000)) follows closely that of Christiano and Gust (1998), with the addition of investment adjustment costs. Given that we have not, as yet, attempted to model the endogenous monetary policy rule being followed by the monetary authority, we would not expect the model to match the correlations and variances in the data. However, subject to this caveat, we find that it can reproduce the stylised fact that there is little relationship between monetary aggregates and either output or inflation, even though the underlying cause of inflation is money growth. We also find that the money-income and money-inflation relationships vary substantially depending on what type of shock is hitting the economy. We take this as a strong argument for structural modelling of the monetary transmission mechanism in which shocks are identified. We show that the model is able to capture important features of the monetary transmission mechanism in the United Kingdom as embodied in the responses of variables to monetary policy shocks.

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