Staff Report 260

Money and Interest Rates With Endogenously Segmented Markets

Patrick J. Kehoe | Stanford University, University College London, Federal Reserve Bank of Minneapolis
Andrew Atkeson | Consultant
Fernando Alvarez | Consultant

Published April 1, 1999

This paper analyses the effects of open market operations on interest rates in a model in which agents must pay a fixed cost to exchange assets and cash. Asset markets are endogenously segmented in that some agents choose to pay the fixed cost and some do not. When the fixed cost is zero, the model reduces to the standard one in which persistent money injections increase nominal interest rates, flatten the yield curve, and lead to a downward-sloping yield curve on average. In contrast, if markets are sufficiently segmented, then persistent money injections decrease interest rates, steepen or even twist the yield curve, and lead to an upward-sloping yield curve on average.

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