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Liquidity Effects, Monetary Policy, and the Business Cycle

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  • Martin Eichenbaum
  • Lawrence J. Christiano

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 the 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 National Bureau of Economic Research, Inc in its series NBER Working Papers with number 4129.

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Date of creation: Aug 1992
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Publication status: published as Journal of Money, Credit and Banking, vol. 27, no. 4, November 1995 Part I pp 1113-1136
Handle: RePEc:nbr:nberwo:4129

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  1. Barro, Robert J, 1978. "Unanticipated Money, Output, and the Price Level in the United States," Journal of Political Economy, University of Chicago Press, vol. 86(4), pages 549-80, August.
  2. Lawrence J. Christiano & Martin Eichenbaum, 1992. "Liquidity effects and the monetary transmission mechanism," Staff Report 150, Federal Reserve Bank of Minneapolis.
  3. Barro, Robert J, 1977. "Unanticipated Money Growth and Unemployment in the United States," American Economic Review, American Economic Association, vol. 67(2), pages 101-15, March.
  4. Steven Strongin, 1992. "The identification of monetary policy disturbances: explaining the liquidity puzzle," Working Paper Series, Macroeconomic Issues 92-27, Federal Reserve Bank of Chicago.
  5. Fuerst, Timothy S., 1992. "Liquidity, loanable funds, and real activity," Journal of Monetary Economics, Elsevier, vol. 29(1), pages 3-24, February.
  6. Cooley, T.F. & Cho, J.O., 1991. "The Business Cycle with Nominal Contracts," Papers 90-07, Rochester, Business - General.
  7. Ben Bernanke, 1990. "The Federal Funds Rate and the Channels of Monetary Transnission," NBER Working Papers 3487, National Bureau of Economic Research, Inc.
  8. Burnside, Craig & Eichenbaum, Martin & Rebelo, Sergio, 1993. "Labor Hoarding and the Business Cycle," Journal of Political Economy, University of Chicago Press, vol. 101(2), pages 245-73, April.
  9. Sims, Christopher A., 1992. "Interpreting the macroeconomic time series facts : The effects of monetary policy," European Economic Review, Elsevier, vol. 36(5), pages 975-1000, June.
  10. 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.
  11. Eric M. Leeper & David B. Gordon, 1991. "In search of the liquidity effect," International Finance Discussion Papers 403, Board of Governors of the Federal Reserve System (U.S.).
  12. Fuerst, Timothy S, 1994. "Optimal Monetary Policy in a Cash-in-Advance Economy," Economic Inquiry, Western Economic Association International, vol. 32(4), pages 582-96, October.
  13. Finn E. Kydland, 1989. "The role of money in a business cycle model," Discussion Paper / Institute for Empirical Macroeconomics 23, Federal Reserve Bank of Minneapolis.
  14. 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.
  15. Stockman, Alan C., 1981. "Anticipated inflation and the capital stock in a cash in-advance economy," Journal of Monetary Economics, Elsevier, vol. 8(3), pages 387-393.
  16. Greenwood, Jeremy & Huffman, Gregory W., 1987. "A dynamic equilibrium model of inflation and unemployment," Journal of Monetary Economics, Elsevier, vol. 19(2), pages 203-228, March.
  17. Robert G. King, 1991. "Money and business cycles," Proceedings, Federal Reserve Bank of San Francisco, issue Nov.
  18. Christiano, Lawrence J., 1988. "Why does inventory investment fluctuate so much?," Journal of Monetary Economics, Elsevier, vol. 21(2-3), pages 247-280.
  19. Grossman, Sanford & Weiss, Laurence, 1983. "A Transactions-Based Model of the Monetary Transmission Mechanism," American Economic Review, American Economic Association, vol. 73(5), pages 871-80, December.
  20. Lucas, Robert Jr., 1990. "Liquidity and interest rates," Journal of Economic Theory, Elsevier, vol. 50(2), pages 237-264, April.
  21. Gali, Jordi, 1992. "How Well Does the IS-LM Model Fit Postwar U.S. Data," The Quarterly Journal of Economics, MIT Press, vol. 107(2), pages 709-38, May.
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