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Rethinking the Liquidity Puzzle: Application of a New Measure of the Economic Money Stock

Author

Listed:
  • William Barnett

    (Department of Economics, University of Kansas)

  • Logan Kelly

    (Department of Economics, Bryant University)

  • John Keating

    (Department of Economics, University of Kansas)

Abstract

Historically, attempts to solve the liquidity puzzle have focused on narrowly defined monetary aggregates, such as non-borrowed reserves, the monetary base, or M1. Many of these efforts have failed to find a short-term negative correlation between interest rates and monetary policy innovations. More recent research uses sophisticated macroeconomic and econometric modeling. However, little research has investigated the role measurement error plays in the liquidity puzzle, since in nearly every case, work investigating the liquidity puzzle has used one of the official monetary aggregates, which have been shown to exhibit significant measurement error. This paper examines the role that measurement error plays in the liquidity puzzle by (i) providing a theoretical framework explaining how the official simple-sum methodology can lead to a liquidity puzzle, and (ii) testing for the liquidity effect by estimating an unrestricted VAR.

Suggested Citation

  • William Barnett & Logan Kelly & John Keating, 2010. "Rethinking the Liquidity Puzzle: Application of a New Measure of the Economic Money Stock," WORKING PAPERS SERIES IN THEORETICAL AND APPLIED ECONOMICS 201002, University of Kansas, Department of Economics, revised Apr 2010.
    • Handle: RePEc:kan:wpaper:201002
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    Cited by:

    1. Chen, Zhengyang & Valcarcel, Victor J., 2025. "Modeling inflation expectations in forward-looking interest rate and money growth rules," EconStor Open Access Articles and Book Chapters, ZBW - Leibniz Information Centre for Economics, vol. 170, pages 1-21.
    2. El-Shagi, Makram & Kelly, Logan, 2019. "What can we learn from country-level liquidity in the EMU?," Journal of Financial Stability, Elsevier, vol. 42(C), pages 75-83.
    3. Barnett, William A. & Su, Liting, 2020. "Financial Firm Production Of Inside Monetary And Credit Card Services: An Aggregation Theoretic Approach," Macroeconomic Dynamics, Cambridge University Press, vol. 24(1), pages 130-160, January.
    4. Kemal Bagzibagli, 2014. "Monetary transmission mechanism and time variation in the Euro area," Empirical Economics, Springer, vol. 47(3), pages 781-823, November.
    5. Barnett, William A. & Han, Qing & Zhang, Jianbo, 2021. "Monetary services aggregation under uncertainty: A behavioral economics extension using Choquet expectation," Journal of Economic Behavior & Organization, Elsevier, vol. 182(C), pages 437-447.
    6. Antonio Ribba, 2017. "What Drives US Inflation and Unemployment in the Long Run?," Economics Bulletin, AccessEcon, vol. 37(2), pages 765-777.
    7. Roy, Ripon & Bashar, Omar H.N.M. & Bhattacharya, Prasad Sankar, 2023. "The cross-industry effects of monetary policy: New evidence from Bangladesh," Economic Modelling, Elsevier, vol. 127(C).
    8. Hiroshi Gunji & Kenji Miyazaki, 2021. "An industrial‐organization approach to conventional and unconventional monetary policy," Economic Notes, Banca Monte dei Paschi di Siena SpA, vol. 50(3), November.
    9. Paul, Sunil & Ramachandran, M., 2011. "Currency equivalent monetary aggregates as leading indicators of inflation," Economic Modelling, Elsevier, vol. 28(4), pages 2041-2048, July.
    10. Muhanji, Stella & Malikane, Christopher & Ojah, Kalu, 2013. "Price and liquidity puzzles of a monetary shock: Evidence from indebted African economies," Economic Modelling, Elsevier, vol. 33(C), pages 620-630.
    11. John W. Keating & Logan J. Kelly & A. Lee Smith & Victor J. Valcarcel, 2019. "A Model of Monetary Policy Shocks for Financial Crises and Normal Conditions," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 51(1), pages 227-259, February.
    12. Keating, John W. & Kelly, Logan J. & Valcarcel, Victor J., 2014. "Solving the price puzzle with an alternative indicator of monetary policy," Economics Letters, Elsevier, vol. 124(2), pages 188-194.
    13. Benchimol, Jonathan & Fourçans, André, 2017. "Money And Monetary Policy In The Eurozone: An Empirical Analysis During Crises," Macroeconomic Dynamics, Cambridge University Press, vol. 21(3), pages 677-707, April.
    14. Makram El-shagi & Logan J Kelly, 2014. "Liquidity in the liquidity crisis: evidence from Divisia monetary aggregates in Germany and the European crisis countries," Economics Bulletin, AccessEcon, vol. 34(1), pages 63-72.
    15. Scharnagl, Michael & Mandler, Martin, 2015. "The relationship of simple sum and Divisia monetary aggregates with real GDP and inflation: a wavelet analysis for the US," VfS Annual Conference 2015 (Muenster): Economic Development - Theory and Policy 112879, Verein für Socialpolitik / German Economic Association.
    16. El-Shagi, Makram & Giesen, Sebastian & Kelly, Logan J., 2015. "The Quantity Theory Revisited: A New Structural Approach," Macroeconomic Dynamics, Cambridge University Press, vol. 19(1), pages 58-78, January.
    17. Antonis Michis, 2011. "Multiscale Analysis of the Liquidity Effect," Working Papers 2011-5, Central Bank of Cyprus.
    18. Antonis Michis, 2015. "Multiscale Analysis of the Liquidity Effect in the UK Economy," Computational Economics, Springer;Society for Computational Economics, vol. 45(4), pages 615-633, April.
    19. Olivier Habimana, 2019. "Wavelet Multiresolution Analysis of the Liquidity Effect and Monetary Neutrality," Computational Economics, Springer;Society for Computational Economics, vol. 53(1), pages 85-110, January.
    20. Habimana, Olivier, 2018. "Asymmetry and Multiscale Dynamics in Macroeconomic Time Series Analysis," MPRA Paper 87823, University Library of Munich, Germany.
    21. El-Shagi, Makram & Giesen, Sebastian & Kelly, Logan J., 2012. "Monetary Policy in a World Where Money (Also) Matters," IWH Discussion Papers 6/2012, Halle Institute for Economic Research (IWH).
    22. Sunil Paul & M. Ramachandran, 2013. "Do Currency Equivalent Monetary Aggregates Have an Edge over Their Simple Sum Counterparts?," South Asian Journal of Macroeconomics and Public Finance, , vol. 2(2), pages 107-143, December.
    23. William A. Barnett & Liting Su, 2017. "Financial Firm Production Of Inside Monetary And Credit Card Services: An Aggregation Theoretic Approach1," WORKING PAPERS SERIES IN THEORETICAL AND APPLIED ECONOMICS 201707, University of Kansas, Department of Economics, revised Oct 2017.

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    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E50 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - General

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