Monetary dynamics with proportional transaction costs and fixed payment periods

Abstract

A general equilibrium model of an economy is presented where people hold money rather than bonds in order to economize on transaction costs. It is not optimal for individuals to instantaneously adjust their money holdings when new information arrives. This (endogenous) delayed response to new information generates a response to a new monetary policy which is quite different from that of standard flexible price models of monetary equilibrium. Though all goods markets instantaneously clear, the transaction cost causes delayed responses in nominal variables to a change in monetary policy. This in turn causes real variables to respond to the new monetary policy.