The Segmented markets Model.

In this model we split the agents in our model economy into two groups. The first group
is consumers, who do not participate in the financial markets. (Remember in our model
the financial markets are simplified, so it consists only of bonds).

The second group are firms with connections and interests to the financial markets- these
would be banks, investment firms etc.

Now suppose the central bank engages in open market operations- this means it buys (or
sells) bonds in the financial market. WE know from our previous work that if the CB
buys bonds this will push up the price of bonds and lower the interest rate.

It is the financial firms that are affected most by this in the model. Thus the market is
split, or segmented, between those that are affected by the central bank action (firms) and
those that are not (consumers). NOW VERY IIMPORTANT__THIS IS A SHORT RUN
MODEL.

So in the short run the fall in interest rate is called a liquidity effect.

To see how the liquidity effect may cause real variables to change, we need to recall the
cash in advance theory we saw previously.

Remember that in the cash in advance model at the end of each period, agents decide
how much money to hold going into the next period. Thus they constrain themselves
to certain amount of cash during each period.

When the central bank increases the money supply by buying bonds the lower ensuing
interest rate reduces the opportunity cost of holding money.

In this model it is stipulated that firms would then hold this money and use it to purchase
more labour- thus increasing output and presumably profits.

Therefore: 1) the demand for labour rises shifts the ND curve right,
2) More labour is supplied in response to the increased demand and the real
wage rate rises (we still have a market clearing model),
3) The increased labour causes more to be produced and the YS curve shifts
to the right- lowering the real interest rate.
4) There is feedback to the labour market because of the lower interest rate-
but remember this response is muted in our models.
5) The feedback mentioned in (4) causes the NS curve to shift to the left
somewhat which further increases the wage rate.
6) In the money market where the demand for money is now assumed to
depend solely on income, L(y), the price level falls since more money is demanded.
 7) In the long run money will find its way to consumers since they receive it as wages.
Once this has occurred for a while then the MS curve shifts to the right and prices rise.

Very important to realize that this worked because firms did not expect the central bank
to increase the money supply- if they anticipate the move then there are no real effects.
But we do not want to set up a situation where firms are always trying to guess whether
the bank will or will not increase the money supply because that interferes with the plans
of firms and in destabilizing to the economy.

Thus it is in everyones best interest for the bank to be transparent and signal to the
markets what it intends to do. This is exactly what the Bank of Canada does.

Is there still a way the model could be useful? Yes, perhaps.

Suppose there was a positive productivity shock. Then firm would want t to hire more
labour and the economy would produce more. The problem here is maybe the firm
doesnt have enough money to hire ALL the labour it might want because it has already
chosen the amount of money to hold going into the current period.

If some how the Bank could see the productivity shock coming (before firms) then it
could increase the money supply just in time for the firm to use it for hiring.

This would mean the Bank has better and more accurate information than firms. One has
to question if this probable.
The diagrams that go along with steps 1-6 are replicated below.
The situation where the Bank may improve on a productivity shock is represented in this
diagram.
Without the banks intervention the supply curve only shifts to YS2 and we get Y2.

With the bank increasing the money supply at the right time we get YS3 and Y3.