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In search of the liquidity effect

  • Eric M. Leeper
  • David B. Gordon

A short-run negative relationship between monetary aggregates and interest rates--the "liquidity effect"--is central to popular, political, and academic discussions of monetary policy. This paper searches for this empirical relationship. We use monthly U.S. data since 1954 to ask if the characterization of the liquidity effect is sensitive to: (i) changes in sample period; (ii) conditioning the correlations on additional variables; (iii) assuming money growth is exogenous, and (iv) treating monetary changes as anticipated or unanticipated. ; The correlations change significantly with each of the four variations. We conclude that a successful search for the liquidity effect requires careful identification of private and policy behavior.

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Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series International Finance Discussion Papers with number 403.

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Date of creation: 1991
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Handle: RePEc:fip:fedgif:403
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  1. Gibson, William E, 1970. "Interest Rates and Monetary Policy," Journal of Political Economy, University of Chicago Press, vol. 78(3), pages 431-55, May-June.
  2. Leonall C. Andersen & Jerry L. Jordon, 1968. "Monetary and fiscal actions: a test of their relative importance in economic stabilization," Review, Federal Reserve Bank of St. Louis, issue Nov, pages 11-23.
  3. Marvin Goodfriend, 1990. "Interest rates and the conduct of monetary policy," Working Paper 90-06, Federal Reserve Bank of Richmond.
  4. Christina D. Romer & David H. Romer, 1989. "Does Monetary Policy Matter? A New Test in the Spirit of Friedman and Schwartz," NBER Working Papers 2966, National Bureau of Economic Research, Inc.
  5. Bryant, R.C., 1991. "Model Representations of Japanese Monetary Policy," Papers 84, Brookings Institution - Working Papers.
  6. 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.
  7. Ray C. Fair, 1977. "The Sensitivity of Fiscal-Policy Effects to Assumptions about the Behavior of the Federal Reserve," Cowles Foundation Discussion Papers 446, Cowles Foundation for Research in Economics, Yale University.
  8. Stephen M. Goldfeld, 1973. "The Demand for Money Revisited," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 4(3), pages 577-646.
  9. Robert B. Litterman & Laurence Weiss, 1983. "Money, Real Interest Rates, and Output: A Reinterpretation of Postwar U.S. Data," NBER Working Papers 1077, National Bureau of Economic Research, Inc.
  10. Stokes, Houston H & Neuburger, Hugh, 1979. "The Effect of Monetary Changes on Interest Rates: A Box-Jenkins Approach," The Review of Economics and Statistics, MIT Press, vol. 61(4), pages 534-48, November.
  11. Robert H. Rasche, 1990. "Demand functions for measures of U.S. money and debt," Proceedings, Board of Governors of the Federal Reserve System (U.S.), pages 113-172.
  12. Lawrence J. Christiano, 1991. "Modeling the liquidity effect of a money shock," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 3-34.
  13. Allan H. Meltzer, 1963. "The Demand for Money: The Evidence from the Time Series," Journal of Political Economy, University of Chicago Press, vol. 71, pages 219.
  14. Rasche, Robert H., 1987. "M1 -- Velocity and money-demand functions: Do stable relationships exist?," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 27(1), pages 9-88, January.
  15. Breusch, T S, 1978. "Testing for Autocorrelation in Dynamic Linear Models," Australian Economic Papers, Wiley Blackwell, vol. 17(31), pages 334-55, December.
  16. 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.
  17. Cooley, Thomas F & LeRoy, Stephen F, 1981. "Identification and Estimation of Money Demand," American Economic Review, American Economic Association, vol. 71(5), pages 825-44, December.
  18. 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.
  19. Gibson, William E, 1970. "The Lag in the Effect of Monetary Policy on Income and Interest Rates," The Quarterly Journal of Economics, MIT Press, vol. 84(2), pages 288-300, May.
  20. Melvin, Michael, 1983. "The Vanishing Liquidity Effect of Money on Interest: Analysis and Implications for Policy," Economic Inquiry, Western Economic Association International, vol. 21(2), pages 188-202, April.
  21. Christopher A. Sims, 1986. "Are forecasting models usable for policy analysis?," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 2-16.
  22. Ralph C. Bryant, 1991. "Model Representations of Japanese Monetary Policy," Monetary and Economic Studies, Institute for Monetary and Economic Studies, Bank of Japan, vol. 9(2), pages 11-61, September.
  23. Robert J. Barro, 1976. "Unanticipated Money Growth and Unemployment in the United States," Working Papers 234, Queen's University, Department of Economics.
  24. Christopher A. Sims, 1982. "Policy Analysis with Econometric Models," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 13(1), pages 107-164.
  25. Lucas, Robert Jr., 1990. "Liquidity and interest rates," Journal of Economic Theory, Elsevier, vol. 50(2), pages 237-264, April.
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