Liquidity effects and market frictions

Two problems exist in standard limited-participation models: (1) the liquid ity effect is not as persistent as in the data; and (2) some nominal variab les are unrealistically volatile. To address these problems, we introduce n ominal wage, price, and portfolio adjustment costs, to better understand ho w each cost affects the size and length of the liquidity effect and the vol atility of inflation following a central-bank policy action. Quantitative a nalysis shows that each of the adjustment costs has a ver), different effec t on the nominal interest rate, inflation and output. The impulse response functions are more realistic in the case with all three adjustment costs th an with any other combination.