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Liquidity effects, monetary policy and the business cycle

  • Lawrence J. Christiano
  • Martin Eichenbaum

This paper presents a flexible-price, quantitative general equilibrium model with the property that a positive money supply shock drives the nominal interest rate down, and aggregate employment, output, and the real wage up. These implications are broadly consistent with postwar U.S. data. The two key features of the model that are responsible for its properties are (1) money shocks have a heterogeneous impact on agents and (2) ex post inflexibilities in production give rise to a very low short-run interest elasticity of money demand. In our model, the extent of the drop in the interest rate after a positive money supply shock depends on the degree to which production is ex post inflexible. Given sufficient ex post inflexibility, the model conforms well with the view, widely held within the U.S. Federal System, that the short-run interest rate elasticity for total reserves is very close to zero. Copyright 1995 by Ohio State University Press.

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Paper provided by Federal Reserve Bank of Chicago in its series Working Paper Series, Macroeconomic Issues with number 92-15.

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Date of creation: 1992
Date of revision:
Handle: RePEc:fip:fedhma:92-15
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  1. 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.
  2. Barro, Robert J., 1978. "Unanticipated Money, Output, and the Price Level in the United States," Scholarly Articles 3450988, Harvard University Department of Economics.
  3. Craig Burnside & Martin Eichenbaum & Sergio Rebelo, 1990. "Labor Hoarding and the Business Cycle," NBER Working Papers 3556, National Bureau of Economic Research, Inc.
  4. Ben S. Bernanke & Alan S. Blinder, 1989. "The federal funds rate and the channels of monetary transmission," Working Papers 89-10, Federal Reserve Bank of Philadelphia.
  5. 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.
  6. Cho, J.O. & Cooley, T.F., 1991. "The Business Cycle with Nominal Contracts," RCER Working Papers 260, University of Rochester - Center for Economic Research (RCER).
  7. Christopher A. Sims, 1992. "Interpreting the Macroeconomic Time Series Facts: The Effects of Monetary Policy," Cowles Foundation Discussion Papers 1011, Cowles Foundation for Research in Economics, Yale University.
  8. Eric M. Leeper & David B. Gordon, 1991. "In search of the liquidity effect," FRB Atlanta Working Paper 91-17, Federal Reserve Bank of Atlanta.
  9. 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.
  10. 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.
  11. 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.
  12. 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.
  13. Christiano, Lawrence J & Eichenbaum, Martin, 1992. "Liquidity Effects and the Monetary Transmission Mechanism," American Economic Review, American Economic Association, vol. 82(2), pages 346-53, May.
  14. Lucas, Robert Jr., 1990. "Liquidity and interest rates," Journal of Economic Theory, Elsevier, vol. 50(2), pages 237-264, April.
  15. Robert G. King, 1991. "Money and business cycles," Proceedings, Federal Reserve Bank of San Francisco, issue Nov.
  16. Christiano, Lawrence J., 1988. "Why does inventory investment fluctuate so much?," Journal of Monetary Economics, Elsevier, vol. 21(2-3), pages 247-280.
  17. repec:tpr:qjecon:v:107:y:1992:i:2:p:709-38 is not listed on IDEAS
  18. 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.
  19. Fuerst, Timothy S., 1992. "Liquidity, loanable funds, and real activity," Journal of Monetary Economics, Elsevier, vol. 29(1), pages 3-24, February.
  20. 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.
  21. 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.
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