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Measuring the liquidity effect

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  • James D. Hamilton

Abstract

This paper develops a measure of the immediate effect on the federal funds rate of an open market operation. Because open market operations are often responses to current or anticipated economic developments, there is a serious problem of simultaneous equations bias in measuring this effect. This paper resolves this problem by developing a proxy for the errors the Federal Reserve makes in forecasting the extent to which Treasury operations will add or drain reserves available to private banks. These errors induce fluctuations in bank reserve which have measurable consequences for the federal funds rate. The paper estimates that a daily decline in nonborrowed reserves of $30 million, if sustained for an entire 14-day reserve maintenance period, will cause the federal funds rate to rise by 10 basic points.

Suggested Citation

  • James D. Hamilton, 1996. "Measuring the liquidity effect," Working Papers in Applied Economic Theory 96-06, Federal Reserve Bank of San Francisco.
  • Handle: RePEc:fip:fedfap:96-06
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