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Liquidity effects, monetary policy and the business cycle

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  • Lawrence J. Christiano
  • Martin Eichenbaum

Abstract

This paper presents new empirical evidence to support the hypothesis that positive money supply shocks drive short-term interest rates down. We then present a quantitative, general equilibrium model which is consistent with this hypothesis. The two key features of our model are that (i) money shocks have a heterogeneous impact on agents and (ii) ex post inflexibilities in production give rise to a very low short-run interest elasticity of money demand. Together, these imply that, in our model, a positive money supply shock generates a large drop in the interest rate comparable in magnitude to what we find in the data. In sharp contrast to sticky nominal wage models, our model implies that positive money supply shocks lead to increases in the real wage. We report evidence that this is consistent with the U.S. data. Finally, we show that our model can rationalize a version of the Real Bills Doctrine in which the monetary authority accommodates technology shocks, thereby smoothing interest rates.

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Bibliographic Info

Paper provided by Federal Reserve Bank of Chicago in its series Working Paper Series, Macroeconomic Issues with number 92-15.

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Date of creation: 1992
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Handle: RePEc:fip:fedhma:92-15

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Keywords: Liquidity (Economics) ; Business cycles;

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References

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  1. Eric M. Leeper & David B. Gordon, 1991. "In search of the liquidity effect," Working Paper, Federal Reserve Bank of Atlanta 91-17, Federal Reserve Bank of Atlanta.
  2. Cho, J.O. & Cooley, T.F., 1991. "The Business Cycle with Nominal Contracts," RCER Working Papers 260, University of Rochester - Center for Economic Research (RCER).
  3. Grossman, Sanford & Weiss, Laurence, 1983. "A Transactions-Based Model of the Monetary Transmission Mechanism," American Economic Review, American Economic Association, American Economic Association, vol. 73(5), pages 871-80, December.
  4. Burnside, Craig & Eichenbaum, Martin & Rebelo, Sergio, 1993. "Labor Hoarding and the Business Cycle," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 101(2), pages 245-73, April.
  5. 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.
  6. Greenwood, Jeremy & Huffman, Gregory W., 1987. "A dynamic equilibrium model of inflation and unemployment," Journal of Monetary Economics, Elsevier, Elsevier, vol. 19(2), pages 203-228, March.
  7. Christiano, Lawrence J & Eichenbaum, Martin, 1992. "Liquidity Effects and the Monetary Transmission Mechanism," American Economic Review, American Economic Association, American Economic Association, vol. 82(2), pages 346-53, May.
  8. Fuerst, Timothy S., 1992. "Liquidity, loanable funds, and real activity," Journal of Monetary Economics, Elsevier, Elsevier, vol. 29(1), pages 3-24, February.
  9. Christiano, Lawrence J., 1988. "Why does inventory investment fluctuate so much?," Journal of Monetary Economics, Elsevier, Elsevier, vol. 21(2-3), pages 247-280.
  10. Bernanke, Ben S & Blinder, Alan S, 1992. "The Federal Funds Rate and the Channels of Monetary Transmission," American Economic Review, American Economic Association, American Economic Association, vol. 82(4), pages 901-21, September.
  11. Fuerst, Timothy S, 1994. "Optimal Monetary Policy in a Cash-in-Advance Economy," Economic Inquiry, Western Economic Association International, Western Economic Association International, vol. 32(4), pages 582-96, October.
  12. Lucas, Robert Jr., 1990. "Liquidity and interest rates," Journal of Economic Theory, Elsevier, Elsevier, vol. 50(2), pages 237-264, April.
  13. Robert J. Barro, 1976. "Unanticipated Money Growth and Unemployment in the United States," Working Papers, Queen's University, Department of Economics 234, Queen's University, Department of Economics.
  14. Steven Strongin, 1992. "The identification of monetary policy disturbances: explaining the liquidity puzzle," Working Paper Series, Macroeconomic Issues, Federal Reserve Bank of Chicago 92-27, Federal Reserve Bank of Chicago.
  15. Robert J. Barro & Mark Rush, 1980. "Unanticipated Money and Economic Activity," NBER Chapters, in: Rational Expectations and Economic Policy, pages 23-73 National Bureau of Economic Research, Inc.
  16. Barro, Robert J, 1978. "Unanticipated Money, Output, and the Price Level in the United States," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 86(4), pages 549-80, August.
  17. Gali, Jordi, 1992. "How Well Does the IS-LM Model Fit Postwar U.S. Data," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 107(2), pages 709-38, May.
  18. Stockman, Alan C., 1981. "Anticipated inflation and the capital stock in a cash in-advance economy," Journal of Monetary Economics, Elsevier, Elsevier, vol. 8(3), pages 387-393.
  19. Finn E. Kydland, 1989. "The role of money in a business cycle model," Discussion Paper / Institute for Empirical Macroeconomics, Federal Reserve Bank of Minneapolis 23, Federal Reserve Bank of Minneapolis.
  20. Robert G. King, 1991. "Money and business cycles," Proceedings, Federal Reserve Bank of San Francisco, Federal Reserve Bank of San Francisco, issue Nov.
  21. Lawrence J. Christiano & Martin Eichenbaum, 1991. "Identification and the Liquidity Effect of a Monetary Policy Shock," NBER Working Papers 3920, National Bureau of Economic Research, Inc.
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