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Identifying the liquidity effect: the case of nonborrowed reserves

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  • Daniel L. Thornton

Abstract

Despite the fact that efforts to identify it empirically have largely been futile, the liquidity effect plays a central role in conventional monetary theory and policy. Recently, however, an increasing volume of empirical work [Christiano and Eichenbaum (1992a,b), Christiano, Eichenbaum and Evans (1994a,b) and Strongin (1995)] has supported the existence of a statistically significant and economically important liquidity effect when nonborrowed reserves is used as the indicator of monetary policy. This paper shows that there is an identification problem associated with using nonborrowed reserves. Specifically, the strong negative relationship between nonborrowed reserves and the funds rate can stem from the presence or absence of a liquidity effect. The paper points out how changes in the demand for borrowed reserves can be used to identify whether the relationship between nonborrowed reserves and the funds rate is due to liquidity effect. The evidence presented suggests that the \"liquidity effect\" that Christiano, Eichenbaum and Evans and others have identified is actually due to the interest sensitivity of the demand for borrowed reserves and the definition linking nonborrowed and borrowed reserves. Consequently, the evidence suggests that the liquidity effect is nil.

Suggested Citation

  • Daniel L. Thornton, 1996. "Identifying the liquidity effect: the case of nonborrowed reserves," Working Papers 1996-002, Federal Reserve Bank of St. Louis.
    • Handle: RePEc:fip:fedlwp:1996-002
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    References listed on IDEAS

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    2. Philippe Bacchetta & Fernando Ballabriga, 2000. "The impact of monetary policy and banks' balance sheets: some international evidence," Applied Financial Economics, Taylor & Francis Journals, vol. 10(1), pages 15-26.

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    Keywords

    Liquidity (Economics); Monetary policy;

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