Title: Monetary Policy and Distribution*Author: Stephen D. Williamson**Affiliations: Department of Economics, Washington University in St. Louis; Federal Reserve Bank ofRichmond; Federal Reserve Bank of St. LouisAbstract: A segmented markets model of monetary policy is constructed, in which a novel featureis goods market segmentation, and its relationship to con ventional asset market segmentation. Theimplications of the model for the response of prices, interest rates, consumption, labor supply, andoutput to monetary policy are determined. As well, optimal monetary policy is studied, as are the costsof inflation. The model features persistent nonneutralities of money, relative price ef f ects of increasesin the money supply, persistent liquidity effects, and a negative Fisher ef fect from a money supplyincrease. A Friedman rule is in general suboptimal.JEL Classifica tion: E4, E5.Key Words: monetary polic y, segmented markets.*The author thanks anonymous referees and conference and sem inar participants at the University ofToronto, the Federal Reserve Bank of Richmond, the Federal Reserve Bank of Cleveland, the Univer-sity of Western Ontario, the SED meetings in Budapest, 2005, and the University of Minnesota forhelpful comments and suggestions.**Correspondence: Stephen D. Williamson, Department of Economics, Washington University in St.Louis, St. Louis, MO 63130; 314-935-9283; [email protected] u. Some proofs and details ofthe analysis are omitted and supplied as a technical appendix in Williamson (2008), for brevity.11 IntroductionIn this paper, a model of the monetary transmission mechanism is constructed, based on market seg-mentation. This builds on i deas in the literature on financial market segmentation and limited participa-tion, but includes an important new element - goods market segmentation. Goods market segmentation,and its relationship to financial market segmentation, is critical in this model in determining the effectsof monetary polic y actions on prices, interest rates, consumption, labor supply, and output.Why do we need another model of the monetary transmission mechanism? Some might arguethat Ne w K eynesian sticky price models, as represented for example in Woodford (2007), provide anadequate account of the key short-run nonneutralities of money and perform well in guiding mone-tary policy. There are good reasons to doubt these vie w s howe ver. First, Bils and Klenow (2004)find evidence on price-setting behavior that seems inconsistent with New Keynesian models. Second,Golosov and Lucas (2007) show, in an explicitly-formulated and calibrated menu-cost model, that thereal effects of monetary policy are quantitatively unimportant. Third, it seems important in analyzingthe monetary transmission mechanism and monetary policy to capture the key frictions in exchangethat make money matter. New Keynesian models do not model these frictions and are therefore atodds with modern monetary theory (Wallace 1998; Lagos and Wright 2005). Thus it seems importantto explore nonneutralities of money that arise for reasons other than price stickiness, in models withexplicit frictions that matter for monetary exchange.Thekeyideasatworkinthemodelarethe following. Some economic agents are connected tofinancial markets, in that they frequently trade financial assets, and are on the recei ving end of thefirst-round effects of changes in monetary policy. In practice, these connected agents are banks andother financial intermediaries and the consumers and firms that trade frequently with these financialintermediaries. Unconnected economic agents trade infrequently in financial markets, and are affectedby monetary policy only indirectly. In practice, of course, there is a v arying degree of connectednessacross economic agents in the economy, but in our model we assume only two types of agents, whoare at the two extremes. Connected economic agents are assumed to trade in each period in financialmarkets, while unconnected economic agents never do.In contrast to a Friedman helicopter drop, which distributes money uniformly across economicagents, outside money injected into the economy by the central bank is initially received just by con-2nected economic agents. How does this money eventually become dispersed through the economy?The ne w money will find its way to unconnected economic agents by way of transactions, and sinceunconnected agents are not trading in financial marke ts, such transactions must involve the exchange ofgoods. That is, the rate at which the new money finds its way from connected to unconnected agents isdetermined by the frequency with which the two groups trade in goods markets. An important elementof our theory is that connected agents are more likely to trade with connected agents, and similarlyfor unconnected agents. The more economic agents tend to trade with their own types (connected orunconnected) the slower will be the process by which the new money is ultimately distribu ted acrossthe population.In the short run, a central bank money injection results in a redistribution of wealth towards con-nected economic agents from the unconnected ones. An important feature of this model is that, oncean increase in the money supply occurs, whether it was anticipated or not is irrelevant for the effectson real and nominal variables. The fact that goods markets are segmented implies that relative priceschange in the short run. That is, in the markets in which connected economic agents trade more fre-quently there will be increases in prices that are initially larger than those observed in unconnectedmarkets. Then, over time, as the size of the money stock decreases in connected markets and increasesin unconnected markets, the conne cted market prices fall and the unconnected market prices rise. Con-nected market prices initially overshoot their long-run v alues, while unconnected market prices adjustgradually to the increase in the aggregate money stock. The changes in the relative prices of goods thatoccur in the short run as a result of a money injection bear some similarity to what occurs in menu costmodels (e.g. Golosov and Lucas 2007). However, the friction that permits these relative price changesis quite different. Prices are perfectly flexible in our model, b u t goods markets are segmented.A central bank money injection increases the dispersion in consumption across the population. Asthe behavior of consumption of connected economic agents and the