Bayesian estimation of liquidity-augmented model with endogenous business formation: application to inflation

Monetary DSGE models typically encompass a New Keynesian framework in which policy operates by targeting the nominal interest rate on an illiquid bond. Price rigidity, in turn, causes real interest rates to respond, which affects the path of real variables and inflation. However, standard monetary policy targets the rate on highly liquid bonds-- typically short-term Treasury bills--and affects returns on other assets through arbitrage opportunities. Recent New Monetarist models capture this channel, giving rise to short-run effects that resemble those of the New Keynesian in addition to long-run effects. Here, we aim to build and estimate an enriched liquidity-augmented monetary business cycle model and compare closely to Smets and Wouters (2007). A key ingredient is endogenous entry of monopolistically competitive firms subject to a sunk entry cost, which promotes persistence, smooths investment dynamics, and allows us to differentiate the tradability of equity from that of capital.

We target the same observable variables--output, consumption, investment, wages, hours, inflation, and the federal funds rate--and extend the range of shocks. Several of the key shocks of interest are demand-related: the fraction of households who seek to shop in a period and the fraction of capital and firm equity which can be sold to finance consumption purchases. In an extended version of the model, we aim to incorporate nominal rigidity, which allows for an integrated theory of inflation, and differentiate consumption goods and services, allowing for a preference shock to each. The idea is for the model to capture consumption shifts from services to goods, as occurred during the pandemic, and its resulting effects on inflation.