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Banks, bonds, and the liquidity effect

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  • Tor Einarsson
  • Milton H. Marquis

Abstract

An "easing" of monetary policy can be characterized by an expansion of bank reserves and a persistent decline in the federal funds rate that, with a considerable lag, induces a pickup in employment, output, and prices. This article presents empirical evidence consistent with this depiction of the dynamic response of the economy to monetary policy actions and develops a theoretical model that exhibits similar dynamic properties. The decline in the federal funds rate is referred to as the "liquidity effect" of an expansionary monetary policy. A key feature of this class of theoretical models is the restriction that households do not quickly adjust their liquid asset holdings, in particular their bank deposit position, in response to an unanticipated change in monetary policy. Without this restriction, there would be no liquidity effect, as interest rates would rise rather than fall in response to an easing of monetary policy due to higher anticipated inflation. A bond market that enables households to lend directly to firms is shown to provide a mechanism that induces persistence in the liquidity effect that is otherwise absent from the predictions of the model.

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Bibliographic Info

Article provided by Federal Reserve Bank of San Francisco in its journal Economic Review.

Volume (Year): (2002)
Issue (Month): ()
Pages: 35-50

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Handle: RePEc:fip:fedfer:y:2002:p:35-50

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Keywords: Monetary policy ; Liquidity (Economics) ; Federal funds;

References

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  1. Fuerst, Timothy S., 1992. "Liquidity, loanable funds, and real activity," Journal of Monetary Economics, Elsevier, Elsevier, vol. 29(1), pages 3-24, February.
  2. Charles L. Evans & David A. Marshall, 1997. "Monetary policy and the term structure of nominal interest rates: evidence and theory," Working Paper Series, Macroeconomic Issues, Federal Reserve Bank of Chicago WP-97-10, Federal Reserve Bank of Chicago.
  3. Rochelle M. Edge, 2000. "Time-to-build, time-to-plan, habit-persistence, and the liquidity effect," International Finance Discussion Papers, Board of Governors of the Federal Reserve System (U.S.) 673, Board of Governors of the Federal Reserve System (U.S.).
  4. Lawrence J. Christiano & Martin Eichenbaum & Charles L. Evans, 1996. "Sticky price and limited participation models of money: a comparison," Staff Report, Federal Reserve Bank of Minneapolis 227, Federal Reserve Bank of Minneapolis.
  5. Christiano, Lawrence J & Eichenbaum, Martin, 1995. "Liquidity Effects, Monetary Policy, and the Business Cycle," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 27(4), pages 1113-36, November.
  6. Christopher A. Sims, 1992. "Interpreting the Macroeconomic Time Series Facts: The Effects of Monetary Policy," Cowles Foundation Discussion Papers, Cowles Foundation for Research in Economics, Yale University 1011, Cowles Foundation for Research in Economics, Yale University.
  7. Eichenbaum, Martin, 1992. "'Interpreting the macroeconomic time series facts: The effects of monetary policy' : by Christopher Sims," European Economic Review, Elsevier, Elsevier, vol. 36(5), pages 1001-1011, June.
  8. Lawrence J. Christiano & Martin Eichenbaum & Charles L. Evans, 1998. "Monetary Policy Shocks: What Have We Learned and to What End?," NBER Working Papers 6400, National Bureau of Economic Research, Inc.
  9. Lawrence J. Christiano & Martin Eichenbaum & Charles Evans, 1994. "The effects of monetary policy shocks: evidence from the flow of funds," Proceedings, Federal Reserve Bank of Dallas, issue Apr.
  10. Tor Einarsson & Milton H. Marquis, 2000. "Bank intermediation and persistent liquidity effects in the presence of a frictionless bond market," Working Paper Series, Federal Reserve Bank of San Francisco 2000-08, Federal Reserve Bank of San Francisco.
  11. Juster, F Thomas & Stafford, Frank P, 1991. "The Allocation of Time: Empirical Findings, Behavioral Models, and Problems of Measurement," Journal of Economic Literature, American Economic Association, vol. 29(2), pages 471-522, June.
  12. Lucas, Robert Jr., 1990. "Liquidity and interest rates," Journal of Economic Theory, Elsevier, Elsevier, vol. 50(2), pages 237-264, April.
  13. Lawrence J. Christiano & Martin Eichenbaum & Charles L. Evans, 1997. "Modeling money," Working Paper Series, Macroeconomic Issues, Federal Reserve Bank of Chicago WP-97-17, Federal Reserve Bank of Chicago.
  14. den Haan, Wouter J & Marcet, Albert, 1990. "Solving the Stochastic Growth Model by Parameterizing Expectations," Journal of Business & Economic Statistics, American Statistical Association, American Statistical Association, vol. 8(1), pages 31-34, January.
  15. Einarsson, Tor & Marquis, Milton H, 2001. "Bank Intermediation over the Business Cycle," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 33(4), pages 876-99, November.
  16. Robert N. McCauley & Rama Seth, 1992. "Foreign bank credit to U.S. corporations: the implications of offshore loans," Quarterly Review, Federal Reserve Bank of New York, Federal Reserve Bank of New York, issue Spr, pages 52-65.
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Cited by:
  1. Max Gillman & Mark N Harris & Michal Kejak, 2007. "The Interaction of Inflation and Financial Development with Endogenous Growth," Money Macro and Finance (MMF) Research Group Conference 2006, Money Macro and Finance Research Group 29, Money Macro and Finance Research Group.

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