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3 Segmented Markets

Standard monetary models (cash-in-advance, money in utility function) imply, counterfactually,


that a persistent increase in the money supply increases nominal interest rates since expected
ination increases. In contrast, in the data nominal interest rates decrease in such episodes (the
Fed decreases the short-term rate when it conducts expansionary open market operations). The
class of models we consider here addresses this shortcoming of standard models by assuming
that asset markets are segmented: only a fraction of agents are present in the bond market when
the Fed conducts the open market operation. To induce these agents to hold the excess currency
the Fed issues, interest rates must decrease, thus giving rise to a liquidity eect. In addition
to explaining the behavior of interest rates, these models can explain additional features of the
data: prices respond slowly to changes in the stock of money supply, monetary expansions are
associated with an increase in the velocity of money, as well as have the potential of generating
more volatile nominal exchange rate movements.
3.1 Cash-in-Advance
Before we introduce asset market frictions, we quickly discuss the standard cash-in-advance
model and its shortcomings. This is an endowment economy with constant endowment y per
period. The representative household consists of two agents: a shopper and a worker. The
worker receives the endowment y, sells it for money and brings the money home: it cannot use
this money again until next period. The shopper buys goods from other households and brings it
home for consumption. Importantly, the household cannot eat its own endowment. At the end
of the period, the household decides how to allocate its assets to currency and bonds: currency
is dominated by bonds in rate of return, but is used for consumption.
Household
Formally, the household maximizes:
max
Mt,ct
E
0

t=0

t
u(c
t
)
s.t.
M
t
+q
t
B
t
= P
t1
y + [M
t1
P
t1
c
t1
] +B
t1
1
where M
t
is the money it has when it enters the period, B
t1
the amount of bonds purchased
at date t 1 that pay 1 unit at date t, q
t
the price of a bond that pays 1 unit in all states at
date t + 1. This ow budget constraint says that the assets the household has are equal to 1)
money worker brought home P
t1
y, 2) unspent money by the shopper M
t1
P
t1
c
t1
, 3) asset
holdings, B
t1
. The household then decides how to split these assets into cash, M
t
and bonds,
q
t
B
t
, where the former are the only means with which the shopper can buy goods. That is, the
cash-in-advance constraint is:
P
t
c
t
M
t
Open Market Operations
The supply of money is determined by the government via open market operations. The
government liabilities are B
t1
at the beginning of date t. It nances these payments via: 1)
issuing new bonds and receiving q
t
B
t
, 2) issuing currency M
t
M
t1
. The governments budget
constraint is:
B
t1
= q
t
B
t
+M
t
M
t1
We assume that the growth rate of the money supply, g
t
= ln
Mt
M
t1
is a random variable (that
households learn at date t) and follows
g
t
= g
t1
+
t
This is the only source of uncertainty in this economy.
Households Decision Rules
Lets go through the First-order conditions (
t
is multiplier on ow budget constraint and

t
on CIA):
M
t
:
t
= E
t

t+1
+
t
c
t
: u

(c
t
) = P
t
[E
t

t+1
+
t
]
B
t
: q
t

t
= E
t

t+1
Rearranging:

t
=
u

(c
t
)
P
t
u

(c
t
)
P
t
= E
t
u

(c
t+1
)
P
t
+
t
q
t
=
1
1 +i
t
= E
t
u

(c
t+1
)
u

(c
t
)
P
t
P
t+1
2
where i
t
is the nominal interest rate.
Solution
Clearly, since
t
=
t
E
t

t+1
=
t
(1 q
t
) , the CIA binds as long as q
t
< 1, i.e the
nominal interest rate is positive. We solve the model by (a) conjecture that
t
> 0, (b) solve for
q
t
given this conjecture and (c) verify that q
t
< 1.
a) since
t
> 0, P
t
c
t
= M
t
. The goods market clearing requires c
t
= y. Also, the price is
simply proportional to M
t
: P
t
=
Mt
y
. The bond Euler equation is then:
q
t
=
1
1 +i
t
= E
t
u

(y)
u

(y)
M
t
/y
M
t+1
/y
= E
t
exp (g
t+1
)
Clearly, if = 0, g
t
is iid, and so q
t
, i
t
is a constant. If > 0 which is a better description
of the data, then a monetary expansion today, g
t
> 0, predicts future expansions, and so q
t
decreases, and i
t
increases. This is the Fisherian expected ination eect.
Models with segmented markets break this result by preventing consumers from freely ex-
changing money for bonds in the asset market. In other words, we will no longer have a unied
budget constraint:
M
t
+q
t
B
t
= P
t1
y + [M
t1
P
t1
c
t1
] +B
t1
but rather 2 constraints, one for the goods market, and another for the asset markets, and we
will impose frictions that prevent consumers from transfering funds from one market to another.
4 Endogenous Asset Market Segmentation
This is the economy studied in Alvarez, Atkeson, Kehoe (2002). Here the goods and asset
markets are segmented: transfering funds from one account to another entails a xed cost, .
Also assume idiosyncratic endowment risk.
There are two sources of uncertainty. Let
t
= (
0
, ...,
t
) be the history of money growth
rates. Let y
t
= (y
0
, ..., y
t
) be the history of endowment received by any individual consumer. y
t
is iid across time and consumers. Let g
_

t
_
denote the probability, as of period 0, of history

t
. Let f
_
y
t
_
denote the probability of history y
t
. Since y is iid, f
_
y
t
_
= f (y
0
) f (y
1
) ...f (y
t
) .
Moreover, the aggregate endowment, Y =
_
yf (y) dy is constant in each period.
3
We make the following timing assumption: the realization of y
t
is not known at the beginning
of period t. Household choices are therefore a function of
_

t
, y
t1
_
.
4.1 Markets
Two physically segmented markets. An asset market and a goods market. The timing is as
follows:
a) the household enters the period taking as given its bond holdings, B
_

t
, y
t1
_
and cash
holdings, P
_

t1
_
y
t1
, that the worker brings home.
b)
t
is realized. The the shopper has m
_

t
, y
t1
_
=
P(
t1
)y
t1
P(
t
)
real cash balances.
c) The asset market opens. The trader purchases state-contingent bonds and decides whether
to transfer funds to the shopper. Let x
_

t
, y
t1
_
the amount transfered. Let z
_

t
, y
t1
_
be an
indicator variable, 1, if a transfer takes place. Hence the traders budget constraint is
_

t+1
_
yt
q
_

t+1
, y
t
|
t
, y
t1
_
B
_

t+1
, y
t
_
+P
_

t
_ _
x
_

t
, y
t1
_
+

z
_

t
, y
t1
_
= B
_

t
, y
t1
_
d) The asset market closes. The goods market opens. The shopper has m
_

t
, y
t1
_
+
x
_

t
, y
t1
_
z
_

t
, y
t1
_
real balances and purchases goods subject to a cash-in-advance con-
straint:
c
_

t
, y
t1
_
m
_

t
, y
t1
_
+x
_

t
, y
t1
_
z
_

t
, y
t1
_
As usual, we work with parameter values that ensure that this constraint binds.
e) The household learns y
t
. The shopper brings P
_

t
_
y
t
dollars home. These are the house-
holds end-of-period cash holdings.
4.2 Government
Issues
t
contingent securities. Starts with debt B
_

t
_
at the beginning of t and nances this
debt by issuing new debt or printing money. Its budget constraint is:
B
_

t
_
= M
_

t
_
M
_

t1
_
+
_

t+1
q
_

t+1
|
t
_
B
_

t+1
_
d
t+1
The government trades securities with nancial intermediaries, and not directly with households.
4
4.3 Financial Intermediaries
Buys
t
contingent securities from the government and sells
_

t
, y
t1
_
securities to households.
Its prots are:
_

t+1
__
yt
q
_

t+1
, y
t
|
t
, y
t1
_
B
_

t+1
, y
t
_
dy
t
q
_

t+1
|
t
_
B
_

t+1
_
_
d
t+1
and its constraint is:
B
_

t+1
_
=
_
yt
B
_

t+1
, y
t
_
f (y
t
) dy
t
which says that the amount of
t+1
contingent bonds it receives from the government is equal
to the total amount of bonds it has to repay in the event
t+1
occurs.
There is a continuum of intermediaries that earn 0 prots in equilibrium. Therefore:
q
_

t+1
, y
t
|
t
, y
t1
_
= q
_

t+1
|
t
_
f (y
t
)
4.4 Preferences
The households objective is to maximize:

t=0

t
_

t
_
y
t1
g
_

t
_
f
_
y
t1
_
U
_
c
_

t
, y
t1
__
4.5 Equilibrium
Goods market must clear:
_
_
c
_

t
, y
t1
_
+z
_

t
, y
t1
_
f (y
t1
) dy
t1
= Y =
_
y
t1
f (y
t1
) dy
t1
Let us next characterize this equilibrium by explicitly writing the Lagrangean associated
with the hoseholds problem. First, iterate forward the ow asset market constraints to obtain
a single intertemporal constraint:

t=0
_

t
_
y
t1
Q
_

t
_
P
_

t
_ _
x
_

t
, y
t1
_
+

z
_

t
, y
t1
_
f (y
t1
) B
0
where B
0
is the initial endowment, assumed equal for all households and Q
_

t
_
is the price at
date 0 of a bond that pays 1$ in the asset market after history
t
. Clearly, Q
_

t
_
= q
_

1
|
0
_
q
_

2
|
1
_
... q
_

t
|
t1
_
.
5
Second, set up the Lagrangean. Let be the multiplier on the budget constraint and the
multiplier on the cash in advance constraint:
L =

t=0

t
_

t
_
y
t1
g
_

t
_
f
_
y
t1
_
[U
_
c
_

t
, y
t1
__
+
+
_

t
, y
t1
_
(m
_

t
, y
t1
_
+x
_

t
, y
t1
_
z
_

t
, y
t1
_
c
_

t
, y
t1
_
)] +

_
B
0

t=0
_

t
_
y
t1
Q
_

t
_
P
_

t
_ _
x
_

t
, y
t1
_
+

z
_

t
, y
t1
_
f (y
t1
)
_
The Focs are:
c
_

t
, y
t1
_
: U
c
_
c
_

t
, y
t1
__
=
_

t
, y
t1
_
x
_

t
, y
t1
_
: Q
_

t
_
P
_

t
_
f (y
t1
) =
t
g
_

t
_
f
_
y
t1
_

t
, y
t1
_
[if z
_

t
, y
t1
_
= 1]
Consider rst those housseholds that decide to pay the xed cost, z
_

t
, y
t1
_
= 1. We have:

t
g
_

t
_
U
c
_
c
_

t
, y
t1
__
= Q
_

t
_
P
_

t
_
This says that all active households have the same consumption
c
_

t
, y
t1
_
= c
A
_

t
_
Consider next the inactive households. Assuming their cash-in-advance constraint binds, they
consume their real balances:
c
_

t
, y
t1
_
= m
_

t
, y
t1
_
=
P
_

t1
_
P (
t
)
y
t1
if z
_

t
, y
t1
_
= 0
Finally, consider the decision of whether to transfer funds or not, z
_

t
, y
t1
_
. Let us impose
the cash-in-advance constraint and rewrite the Lagrangean as:
L =

t=0

t
_

t
_
y
t1
g
_

t
_
f
_
y
t1
_
[U
_
c
A
_

t
__
z
_

t
, y
t1
_
+U
_
m
_

t
, y
t1
__ _
1 z
_

t
, y
t1
__
+
_
B
0

t=0
_

t
_
y
t1
Q
_

t
_
P
_

t
_ _
x
_

t
, y
t1
_
+

z
_

t
, y
t1
_
f (y
t1
)
_
By inspecting the Lagrangean, we can see that
= L(z = 1)L(z = 0) =
t
g
_

t
_
f
_
y
t1
_ _
U
_
c
A
_

t
__
U
_
m
_

t
, y
t1
__
Q
_

t
_
P
_

t
_ _
x
_

t
, y
t1
_
+
_
Since Q
_

t
_
P
_

t
_
=
t
g
_

t
_
f
_
y
t1
_
U
c
_
c
A
_

t
__
for active households and the amount they
transfer is equal to x = c
A
m, then
6

t
g (
t
) f (y
t1
)
= U
_
c
A
_
U (m) U
c
_
c
A
_ _
c
A
m+

Hence, the household transfer funds if:


h(m) = U
_
c
A
_
U (m) U
c
_
c
A
_ _
c
A
m+

> 0
One can show that h(m) is strictly convex, h

(m) < 0 if m < c


A
, h

(m) = 0 if m = c
A
and
h

(m) > 0 if m > c


A
. Moreover, h
_
c
A
_
= U
c
_
c
A
_
< 0 so h(m) = 0 has 2 solutions, m
L
and
m
H
. Thus, all households with m (m
L
, m
H
) are inactive, and the rest transfer funds.
Finally, compute the consumption of active households from the resource constraint. First,
note that the cash-in-advance constraint is binding for all households, so combining the goods
and money market clearing, we have:
M
_

t
_
P (
t
)
=
_
c
_

t
, y
t1
_
f
_
y
t1
_
dy
t1
=
_
y
t1
f
_
y
t1
_
dy
t1
= Y
and thus
P(
t
)
P(
t1
)
=
t
. Let y
L
_

t
_
=
t
m
L
and y
H
_

t
_
=
t
m
H
denote the participation cutos
in the y space. Then we have
Y = c
A
_

t
_ _
F
_
y
L
_

t
__
+ 1 F
_
y
H
_

t
__
+
1

t
_
y
H(
t
)
y
L
(
t
)
yf (y) dy
and so
c
A
_

t
_
=
Y
1
t
_
y
H(
t
)
y
L
(
t
)
yf (y) dy
[F (y
L
(
t
)) + 1 F (y
H
(
t
))]
Although

t
c
A
_

t
_
is, in general, dicult to sign, AAK work with parameter values that
ensure that

t
c
A
_

t
_
> 0, so that active households benet from money expansions. Intuitively,
an increase in
t
raises c
A
since it erodes the cash balances of inactive households (money
injections act as a tax on inactive households). However, higher
t
also widens the participation
region: more households nd it optimal to participate and this tends to decrease the per-capita
amount of resources available to these agents. As long as there is not too much mass of agents
in the neighborhood of the cutos, the rst eect dominates.
7
4.6 Asset Prices
Let us compute the price of a risk-free bond that pays 1 unit in all states,
q
t
=
_
q
_

t+1
|
t
_
d
t+1
=
_
g
_

t+1
|
t
_ U
c
_
c
_

t+1
, y
t
__
/P
_

t+1
_
U
c
(c (
t
, y
t1
)) /P (
t
)
d
t+1
1
1 +i
t
= q
t
= E
t
_
c
A
(
t+1
)
c
A
(
t
)
_

t+1
where we have used the fact that
q
_

t+1
|
t
_
=
Q
_

t+1
_
Q(

)
= g
_

t+1
|
t
_ U
c
_
c
_

t+1
, y
t
__
/P
_

t+1
_
U
c
(c (
t
, y
t1
)) /P (
t
)
As earlier, suppose
t
is iid. If
t
unexpectedly increases, the consumption of active house-
holds increases as well and so i
t
decreases: a liquidity eect. AAK derive conditions under
which nominal interest rates decrease even in the present of serially correlated money growth
rates. Intuitively, the real interest rate declines here to induce active household to consume the
transfers they receive from the inactive households whose real balances are taxed by a monetary
expansion. As long as the decline in interest rates is large enough to not be oset by expected
ination, nominal interest rates decline as well.
4.7 Real Exchange Rates
AAK also use the model to think about its implications for real exchange rates. In the data,
real exchange rates are almost as volatile, and strongly correlated with nominal exchange rates.
Flexible price models cannot replicate these features of the data since the real exchange rate is
equal to
RER
t
=
U

(c

t
)
U

(c
t
)
=
U

(Y

)
U

(Y )
= 1
In contrast, in this model,
RER
t
=
U

_
c
A
t
(

t
)
_
U

_
c
A
t
(
t
)
_
and thus comoves with monetary policy. Moreover, the nominal exchange rate is equal to
NER
t
= RER
P
t
P

t
= RER
M
t
M

t
and also correlated with the real exchange rate. AAK show that for parametrizations in which
the consumption of active households is strongly aected by
t
, the model can reproduce the
volatility and correlation of real/nominal exchange rates in the data.
8
A second implication of the model is that in environments with high trend ination, most
agents are active and hence the consumption of active households is less aected by variation in
monetary policy. In such environments real and nominal exchange rates are less correlated and
the volatility of nominal exchange rates is much greater than that of real exchange rates. These
features are consistent with the data. [See the last 2 gures]
9
Fig. 1.Timing in the two markets
money 85