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Liquidity Effects and the Monetary Transmission Mechanism

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Author Info
Lawrence J. Christiano
Martin Eichenbaum

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Abstract

Several recent papers provide strong empirical support for the view that an expansionary monetary policy disturbance generates a persistent decrease in interest rates and a persistent increase in output and employment. Existing quantitative general equilibrium models, which allow for capital accumulation, are inconsistent with this view. There does exist a recently developed class of general equilibrium models which can rationalize the contemporaneous response of interest rates, output, and employment to a money supply shock. However, a key shortcoming of these models is that they cannot rationalize persistent liquidity effects. This paper discusses the basic frictions and mechanisms underlying this new class of models and investigates one avenue for generating persistence. We argue that once a simplified version of the model in Christiano and Eichenbaum (1991) is modified to allow for extremely small costs of adjusting sectoral flow of funds, positive money shocks generate long-lasting, quantitatively significant liquidity effects, as well as persistent increases in aggregate economic activity.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 3974.

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Date of creation: Jan 1992
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Publication status: published as American Economic Review, Papers and Preceedings Vol. 82, No. 2, pp. 346-353 May 1992
Handle: RePEc:nbr:nberwo:3974

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This item is featured on the following reading lists:
  1. Advanced Monetary Theory and Policy (ECON 447)
  2. Top 1‰ items by number of citations weighted by simple impact factors
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References listed on IDEAS
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  1. Reichenstein, William, 1987. "The Impact of Money on Short-term Interest Rates," Economic Inquiry, Oxford University Press, vol. 25(1), pages 67-82, January.
  2. Lawrence J. Christiano, 1991. "Modeling the liquidity effect of a money shock," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 3-34. [Downloadable!]
  3. Lucas, Robert Jr., 1990. "Liquidity and interest rates," Journal of Economic Theory, Elsevier, vol. 50(2), pages 237-264, April. [Downloadable!] (restricted)
  4. Akerlof, George A, 1979. "Irving Fisher on His Head: The Consequences of Constant Threshold-Target Monitoring of Money Holdings," The Quarterly Journal of Economics, MIT Press, vol. 93(2), pages 169-87, May. [Downloadable!] (restricted)
  5. Robert G. King, 1991. "Money and business cycles," Proceedings, Federal Reserve Bank of San Francisco, issue Nov.
  6. Bernanke, Ben S & Blinder, Alan S, 1992. "The Federal Funds Rate and the Channels of Monetary Transmission," American Economic Review, American Economic Association, vol. 82(4), pages 901-21, September. [Downloadable!] (restricted)
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  7. Christopher A. Sims, 1992. "Interpreting the Macroeconomic Time Series Facts: The Effects of Monetary Policy," Cowles Foundation Discussion Papers 1011, Cowles Foundation, Yale University. [Downloadable!]
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