Central Bank Lending, Inflation and Output Dynamics in a Limited Participation Model

This paper seeks to evaluate the effects of expansionary monetary policy by the central bank on inflation, output and employment in a limited-participation model for different parameters value of inter-temporal elasticity of substitution and the Frisch (inverse of the labor supply) elasticity. To this end, a modified cash in advance model in line with Lucas (1990), Christiano (1991) and Fuerst (1992) is utilized to account for liquidity effect and anticipated inflation effect simultaneously. The utility function in this model has a CRRA specification in order to perform the sensitivity analysis of the key variables of the model. A range of parameter values for the economy of Iran is used to show the dependency of the results on the size of the coefficient of relative risk aversion and the Frisch elasticity. The simulation results, given the structure and limitation of our model, show that the injection of liquidity to the banking system is inflationary and is not a reliable policy to increase output. We obtained similar results with different parameter values, except for the risk aversion parameter below unity and Frisch elasticity below two. Consistent with prior research, when these parameters are higher, the liquidity effect on output and employment becomes weaker.