A Two-Agent Model of Inflation

Abstract

Models of inflation usually have monetary policy affecting the economy through either an interest rate channel or a monetary/credit quantity channel but not through both simultaneously. It is argued here that policy is transmitted via two distinct types of agents – those that are and that are not liquidity-constrained. The implication is that both interest rate and monetary channels must be seen as complementary, joint indicators of inflation and must both be incorporated into models of inflation. A formal representation of price level determination and behaviour in this two-agent framework is provided and evaluated econometrically using US data.