Money demand and nominal debt: An equilibrium model of the liquidity effect

Recently, strong empirical evidence has been found to support the existence of a liquidity effect. Existing models of this effect, however, are not completely satisfactory. We attempt to overcome the shortcomings in previous theories by modeling money demand as a function of both expenditures on current output and transactions linked to nominal debt. Combined with several money supply processes, we show that such a money demand specification can plausibly explain a persistent liquidity effect. Unlike most other models of the liquidity effect, ours assumes prices are flexible and monetary policy has no impact on the real interest rate or output.