Role of expected inflation in explaining the liquidity puzzle

Some previous studies have reported puzzling responses of macroeconomic variables, including liquidity, price, and exchange rate anomalies, following central banks' policy disturbances. The objective of this paper is to address the anomalies, with a focus on the liquidity puzzle, by disentangling the policy effect on expected inflation from its effect on the expected real interest rate (ex-ante). First, I extract the ex-ante real rate and expected inflation from the one-year Treasury yield using the Blanchard-Quah (1989) SVAR together with the Fisher equation. Then, I use these decomposed variables along with other variables to develop a Canada-specific open-economy SVAR model. Applying Bayesian estimation via Gibbs sampling, I find that shocks in M1 decrease the expected real interest rate, increase expected inflation, depreciate the Canadian dollar, and boost output. I posit that the increase in nominal interest rates found in previous studies likely reflects a dominant rise in inflationary expectations that outweighs the fall in the ex-ante real rate. These results highlight the importance of isolating expected inflation from real interest rate movements for policy analysis and underscore the need for the Bank of Canada to closely monitor money supply trends to enhance the effectiveness of its policy framework.