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Inflationary expectations, money growth, and the vanishing liquidity effect of money on interest : a further investigation

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  • Yash P. Mehra
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    Abstract

    Market participants recognize two opposing effects of money supply growth on interest rates: a temporary liquidity effect and a permanent expectations effect. That the latter dominates in the long run is clear—a sustained increase in money growth causes proportionally higher interest rates due to a rise in inflationary expectations. In the short run, however, this interest-raising expectations effect is to some degree offset by the interest-lowering liquidity effect as monetary acceleration initially gluts the market for money balances. Depending on the relative strengths of these two opposing forces, increased money growth may lower interest rates for a while. In the second article in this Review, “Inflationary Expectations, Money Growth, and the Vanishing Liquidity Effect of Money on Interest: A Further Investigation,” Yash Mehra examines the historical response of interest rates to changes in money growth and finds that the pattern of response has changed substantially over time. During the ‘50s and ‘60s, accelerations in money growth significantly lowered interest rates in the short run through the liquidity effect. In the ‘70s, however, the liquidity effect was no longer significant. Triggered by high and variable rates of inflation, inflationary expectations became more responsive to changes in money growth and the expectations effect began to dominate the liquidity effect even in the short run. As a result, the temporary lowering of interest rates following an acceleration of money growth is now shorter lived and less pronounced than it was during the ‘50s and ‘60s.

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    Bibliographic Info

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

    Volume (Year): (1985)
    Issue (Month): Mar ()
    Pages: 23-35

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    Handle: RePEc:fip:fedrer:y:1985:i:mar:p:23-35:n:v.71no.2

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    Keywords: Money;

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    1. Darby, Michael R, 1975. "The Financial and Tax Effects of Monetary Policy on Interest Rates," Economic Inquiry, Western Economic Association International, vol. 13(2), pages 266-76, June.
    2. Melvin, Michael, 1983. "The Vanishing Liquidity Effect of Money on Interest: Analysis and Implications for Policy," Economic Inquiry, Western Economic Association International, vol. 21(2), pages 188-202, April.
    3. Mishkin, Frederic S, 1982. " Monetary Policy and Short-Term Interest Rates: An Efficient Markets-Rational Expectations Approach," Journal of Finance, American Finance Association, vol. 37(1), pages 63-72, March.
    4. Ashley, Richard, 1984. "A Simple Test for Regression Parameter Instability," Economic Inquiry, Western Economic Association International, vol. 22(2), pages 253-68, April.
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    7. Poole, William, 1982. "Federal Reserve Operating Procedures: A Survey and Evaluation of the Historical Record since October 1979," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 14(4), pages 575-96, November.
    8. Cornell, Bradford, 1983. "The Money Supply Announcements Puzzle: Review and Interpretation," American Economic Review, American Economic Association, vol. 73(4), pages 644-57, September.
    9. Robert J. Gordon, 1979. "New Evidence that Fully Anticipated Monetary Changes Influence Real Output After All," Discussion Papers 369, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
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    11. Gibson, William E, 1970. "The Lag in the Effect of Monetary Policy on Income and Interest Rates," The Quarterly Journal of Economics, MIT Press, vol. 84(2), pages 288-300, May.
    12. DeRosa, Paul & Stern, Gary H., 1977. "Monetary control and the federal funds rate," Journal of Monetary Economics, Elsevier, vol. 3(2), pages 217-230, April.
    13. Mullineaux, Donald J, 1980. "Inflation Expectations and Money Growth in the United States," American Economic Review, American Economic Association, vol. 70(1), pages 149-61, March.
    14. Rodney L. Jacobs & Robert A. Jones, 1978. "Price Expectations in the United States: 1947-1973," UCLA Economics Working Papers 107, UCLA Department of Economics.
    15. Peek, Joe, 1982. "Interest Rates, Income Taxes, and Anticipated Inflation," American Economic Review, American Economic Association, vol. 72(5), pages 980-91, December.
    16. Carlson, John A, 1979. "Expected Inflation and Interest Rates," Economic Inquiry, Western Economic Association International, vol. 17(4), pages 597-608, October.
    17. Gramlich, Edward M, 1983. "Models of Inflation Expectations Formation: A Comparison of Household and Economist Forecasts," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 15(2), pages 155-73, May.
    18. Robert Mundell, 1963. "Inflation and Real Interest," Journal of Political Economy, University of Chicago Press, vol. 71, pages 280.
    19. Cornell, Bradford, 1983. "Money Supply Announcements and Interest Rates: Another View," The Journal of Business, University of Chicago Press, vol. 56(1), pages 1-23, January.
    20. Stephen H. Axilrod, 1985. "U.S. monetary policy in recent years: an overview," Federal Reserve Bulletin, Board of Governors of the Federal Reserve System (U.S.), issue Jan, pages 14-24.
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    Cited by:
    1. Vilasuso, Jon, 1999. "The Liquidity Effect and the Operating Procedure of the Federal Reserve," Journal of Macroeconomics, Elsevier, vol. 21(3), pages 443-461, July.

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