Real consequences of open market operations: the role of limited commitment

By Francesco Carli and Pedro Gomis Porqueras

http://d.repec.org/n?u=RePEc:pra:mprapa:94088&r=dge

We study how limited commitment in credit markets affects the implementation of open market operations and characterize when they result in real indeterminacies and when they have real effects. To do so, we consider a frictional and incomplete market framework where agents face stochastic trading opportunities and limited commitment in some markets. When limited commitment does not constraint agents’ choices, we find necessary and sufficient conditions for the existence of a unique monetary equilibrium. However, real indeterminacies are possible when buyers face a binding no-default constraint. We also show that when the no-default constraint binds and bonds are not priced fundamentally, open market operations generically have real effects. A sale of government bonds can increase or decrease interest rates, depending on the nature of equilibria. The direction of the interest rate effects critically depend on the size of the liquidity premium on government bonds. Finally, government bonds purchases can be used to rule out real indeterminacies, thus finding another rationale for such policy.

In principle, monetary policy should not matter, only real quantities are relevant. But it does due to the monetary illusion. A few mechanisms for this illusion have been demonstrated, here is another one.

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