Liquidity, Interest Rates and Banking (Financial Institutions and Services) by Jeffrey Morrey

Chapter 1
THE LIQUIDITY EFFECT:
A SURVEY OF THE LITERATURE
Mark E. Wohar
Department of Economics, University of Nebraska at Omaha, RH-512K,
Omaha, NE, USA
Abstract
The short-run response of interest rates to changes in the nominal money supply has
important implication for macroeconomic theory and policy. The conventional view is that
positive money supply shocks, ceteris paribus, have a temporary but persistent negative
effects on nominal and real interest rates as economic agents attempt to get rid of money
balances through the purchase of bonds. The more inelastic is money demand, the larger is the
effect. This “liquidity effect” view is the issue of this paper. This paper surveys both the
theoretical and empirical literature related to the liquidity effect. The liquidity effect is
inconsistent with many real business cycle models, which allow money shocks to have a
positive effect only on nominal interest rates through the effect of inflationary expectations
(the “fisher effect”). If the liquidity effect is found to be empirically relevant, theoretical
models of the business cycle must account for this fact (e.g. Lucas 1990; Christiano 1991;
Fuerst 1992; and Christiano and Eichenbaum 1992a,b). Leeper (1992) notes that the existence
of a liquidity effect can have important consequences for the conduct of monetary policy. The
empirical evidence of a liquidity effect is mixed. The pioneering studies of Cagan and
Gandofi (1969), Gibson (1970b), Cagan (1972), and Cochrane (1989) support the existence of
a liquidity effect. Mishkin (1982), Melvin (1983), Reichenstein (1987), Leeper and Gordon
(1992), Pagan and Robertson (1995,1998) and Thornton (2001a,b) fail to find a negative
relationship between some measure of money and an interest rate. or find that the effect is not
robust across sub-periods. This failure to find evidence of a liquidity effect has been called the
“liquidity puzzle”. Increases in money supply that leads to an increase in interest rates (a
liquidity Puzzle) has been surveyed by Reichenstein (1987) and was re-documented by Leeper
and Gordon (1992). Christiano (1991), Christiano and Eichenbaum (1992b), Gali (1992),
Strongin (1995), Gordon and Leeper (1994), Strongin (1995), Lastrapes and Selgin (1995),
Christiano, Eichenbaum and Evans (1996a,b), Leeper, Sims and Zha (1996), Hamilton (1997),
Bernanke and Mihov (1998a, 1998b), all find a liquidity effect with a number of authors
arguing that the liquidity puzzle is the result of problems with econometric identification.

1. Introduction
The short-run response of interest rates to changes in the nominal money supply has
important implication for macroeconomic theory and policy. The conventional view is that
positive money supply shocks, ceteris paribus, have a temporary but persistent negative
effects on nominal and real interest rates as economic agents attempt to get rid of money
balances through the purchase of bonds. The more inelastic is money demand, the larger is
the effect. Each morning at the trading desk at the Federal Reserve Bank of New York (Desk)
open market operations are conducted to adjust the supply of reserves in the banking system
in order to achieve the target Federal Funds Rate set by the Federal Open Market Committee
(FOMC). This manipulation of reserves to affect the federal funds rate presupposes the
existence of a liquidity effect. This “liquidity effect” view is the issue of this paper.
Christiano (1996, p. 3) defines the liquidity effect as "[a]n exogenous, persistent, upward
shock in the growth rate of the monetary base engineered by the central bank and not
associated with any current or prospective adjustment in distortionary taxes, drives the
nominal interest rate down for a significant period of time." This paper surveys both the
theoretical and empirical literature related to the liquidity effect. The liquidity effect is
inconsistent with many real business cycle models, which allow money shocks to have a
positive effect only on nominal interest rates through the effect of inflationary expectations
(the “fisher effect”). If the liquidity effect is found to be empirically relevant, theoretical
models of the business cycle must account for this fact (e.g. Lucas 1990; Christiano 1991;
Fuerst 1992; and Christiano and Eichenbaum 1992a,b). Leeper (1992) notes that the existence
of a liquidity effect can have important consequences for the conduct of monetary policy.
Limited participation models attracted attention because they replicate the effects of monetary
policy on interest rates. Examples include Lucas (1990), Fuerst (1992), and Christiano and
Eichenbaum (1992a, 1995).
Although the relation between interest rates and money supply was known for a long
time, the first person to use the term liquidity effect was Milton Friedman (1968,1969).
Friedman provided a very simple argument to justify the liquidity effect. He noted that when
individuals believe that they are going to hold excess money they purchase bonds in an
attempt to get rid of excess money balances, which increase bond prices and decrease real and
nominal interest rates.
Section 2 of the paper will discuss briefly some of the theoretical literature related to the
liquidity effect as a lead into the empirical literature. Section 3 will discuss the extant
literature that examines the empirical aspects of the liquidity effect. Section 4 provides a short
discussion of the history of Federal Reserve Operating procedures. Section 5 concludes the
paper.
2. Theoretical Papers
From a theoretical perspective, models that attempt to explain the liquidity effect vary
between two polar cases. At one pole are studies of the behavior of money markets focusing
on the micro-structure and on interbank relationships (Ho and Saunders 1985; Kopecky and
Tucker 1993; Hamilton 1996; and Furfine 2000). At the opposite pole there are the textbook
monetary theory models of money markets (Campbell 1987; Coleman, Gilles, Labadie 1996)

Liquidity, Interest Rates and Banking (Financial Institutions and Services) by Jeffrey Morrey