STICKY PRICE AND LIMITED PARTICIPATION MODELS OF MONEY - A COMPARISON

We provide new evidence that models of the monetary transmission mecha nism should be consistent with at least the following facts. After a c ontractionary monetary policy shock, the aggregate price level respond s very little, aggregate output falls, interest rates initially rise, real wages decline by a modest amount, and profits fall. We compare th e ability of sticky price and limited participation models with fricti onless labor markets to account for these facts. The key failing of th e sticky price model lies in its counterfactual implications for profi ts. The limited participation model can account for all the above fact s, but only if one is willing to assume a high labor supply elasticity (2 percent) and a high markup (40 percent). The shortcomings of both models reflect the absence of labor market frictions, such as wage con tracts or factor hoarding, which dampen movements in the marginal cost of production after a monetary policy shock. (C) 1997 Elsevier Scienc e B.V.