On Optimal Monetary Policy in a Liquidity Effect Model

This paper examines the implications of introducing a variable rate of time preference on the role of monetary policy in a dynamic general equilibrium framework explicitly designed to capture liquidity effects. Variable time preference is incorporated by allowing the discount factor applied to future utility to be decreasing in contemporaneous utility. The model is a more general one, in the sense that the fixed discount factor economy is nested as a special case. Numerical simulations of the more general model indicate that for a range of parameters optimal monetary policy can be qualitatively different. This is in spite of the fact that there are very small quantitative differences in the magnitude of monetary non-neutralities, such as liquidity effects, in the fixed and flexible discount factor environments. Furthermore, within this range, monetary policy is less activist, in the sense that it is procyclical to productivity shocks, as opposed to being countercyclical as in the fixed time preference model.