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Searching for the Liquidity Effect in Canada

  • Ben Fung

    (Bank of Canada)

  • Rohit Gupta

    (Bank of Canada)

This paper examines the empirical evidence of the liquidity effect in Canada. In the presence of the liquidity effect, the initial impact of an unanticipated expansionary monetary policy is to lower nominal and real interest rates for a short period of time. Eventually, however, the anticipated inflation effect will come into force and dominate the liquidity effect as people adjust their inflation expectations to the new money growth rate. As a result, interest rates will then increase. In this paper, we use vector autoregression (VAR) methods to study how interest rates, output and exchange rates respond to shocks to monetary policy. We use the excess cash reserves of the chartered banks and the surprise component of excess cash reserves as measures of monetary policy shocks. Shocks to monetary policy are measured by the orthogonalized innovations to these liquidity variables. We find that expansionary shocks to monetary policy are followed by declines in the interest rate, increases in output, and depreciations of the Canadian dollar. The results are robust to different orderings of the variables used in the VAR estimation. The response of the interest rate to monetary policy shocks is robust to different measures of liquidity, but the responses of other variables vary slightly.

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Paper provided by EconWPA in its series Macroeconomics with number 9502004.

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Length: 51 pages
Date of creation: 03 Feb 1995
Date of revision:
Handle: RePEc:wpa:wuwpma:9502004
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  1. Rotemberg, Julio J, 1984. "A Monetary Equilibrium Model with Transactions Costs," Journal of Political Economy, University of Chicago Press, vol. 92(1), pages 40-58, February.
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  10. Duguay, Pierre, 1994. "Empirical evidence on the strength of the monetary transmission mechanism in Canada: An aggregate approach," Journal of Monetary Economics, Elsevier, vol. 33(1), pages 39-61, February.
  11. Pierre Duguay & Stephen Poloz, 1994. "The Role of Economic Projections in Canadian Monetary Policy Formulation," Canadian Public Policy, University of Toronto Press, vol. 20(2), pages 189-199, June.
  12. Watson, Mark W., 1986. "Vector autoregressions and cointegration," Handbook of Econometrics, in: R. F. Engle & D. McFadden (ed.), Handbook of Econometrics, edition 1, volume 4, chapter 47, pages 2843-2915 Elsevier.
  13. 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.
  14. Lucas, Robert Jr., 1990. "Liquidity and interest rates," Journal of Economic Theory, Elsevier, vol. 50(2), pages 237-264, April.
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  18. Martin Eichenbaum & Charles L. Evans, 1993. "Some Empirical Evidence on the Effects of Monetary Policy Shocks on Exchange Rates," NBER Working Papers 4271, National Bureau of Economic Research, Inc.
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  20. Bernanke, Ben S., 1986. "Alternative explanations of the money-income correlation," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 25(1), pages 49-99, January.
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  22. Engle, Robert F & Granger, Clive W J, 1987. "Co-integration and Error Correction: Representation, Estimation, and Testing," Econometrica, Econometric Society, vol. 55(2), pages 251-76, March.
  23. John W. Keating, 1992. "Structural approaches to vector autoregressions," Review, Federal Reserve Bank of St. Louis, issue Sep, pages 37-57.
  24. Gali, Jordi, 1992. "How Well Does the IS-LM Model Fit Postwar U.S. Data," The Quarterly Journal of Economics, MIT Press, vol. 107(2), pages 709-38, May.
  25. Matthew D. Shapiro & Mark W. Watson, 1988. "Sources of Business Cycle Fluctuations," Cowles Foundation Discussion Papers 870, Cowles Foundation for Research in Economics, Yale University.
  26. Sims, Christopher A & Stock, James H & Watson, Mark W, 1990. "Inference in Linear Time Series Models with Some Unit Roots," Econometrica, Econometric Society, vol. 58(1), pages 113-44, January.
  27. J. F. Dingle & G. R. Sparks & M. A. Walker, 1972. "Monetary Policy and the Adjustment of Chartered Bank Assets," Canadian Journal of Economics, Canadian Economics Association, vol. 5(4), pages 494-514, November.
  28. 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.
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