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

Kelly, Logan and Barnett, William A. and Keating, John W. (2010): Rethinking the Liquidity Puzzle: Application of a New Measure of the Economic Money Stock.

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.

• Item Type: MPRA Paper
• Language: English
• Keywords: Liquidity Puzzle, Monetary Policy, Monetary Aggregation, Money Stock, Divisia Index Numbers
• Subjects: E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E43 - Interest Rates: Determination, Term Structure, and Effects; E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E50 - General

References

Anderson, Richard G., and Robert H. Rasche. 2000. Retail sweep programs and bank reserves, 1994--1999. Federal Reserve Bank of St. Louis.

Arrow, K J, and G H Hahn. 1971. General Competitive Analysis: San Francisco: Holden-Day.

Barnett, William A. 1980. Economic Monetary Aggregates: An Application of Index Number and Aggregation Theory. Journal of Econometrics 14: 11-48. Reprinted in The Theory of Monetary Aggregation, William Barnett and Apostolos Serletis (eds.), 2000, Amsterdam: Elsevier, 11-48.

———. 1991. A Reply to Julio J. Rotemberg. In: Belongia, M. T. (Ed.), Monetary Policy on the 75th Anniversary of the Federal Reserve System. Proceedings of the Fourteenth Annual Economic Policy Conference of the Federal Reserve Bank of St. Louis, Kluwer, pp. 189-222. Reprinted in The Theory of Monetary Aggregation, William Barnett and Apostolos Serletis (eds.), 2000, Amsterdam: Elsevier, 296-306.

———. 1995. Exact Aggregation Under Risk. In: Barnett, W. A., Salles,M., Moulin, H., Schoeld, N. (Eds.), Social Choice, Welfare and Ethics. Proceedings of the Eighth International Symposium in Economic Theory and Econometrics, Cambridge University Press, pp. 353-374. Reprinted in The Theory of Monetary Aggregation, William Barnett and Apostolos Serletis (eds.), 2000, Amsterdam: Elsevier, 195-216.

Barnett, William A, Yi Liu, and Mark Jensen. 1997. CAPM Risk Adjustment for Exact Aggregation Over Financial Assets. Macroeconomic Dynamics 1 (2):485-512. Reprinted in The Theory of Monetary Aggregation, William Barnett and Apostolos Serletis (eds.), 2000, Amsterdam: Elsevier, 245-273.

Barnett, William A., Unja Chae, and John W. Keating. 2005. The Discounted Economic Stock of Money with VAR Forecasting. Annals of Finance 2 (2):229-258. Barnett, William A., and Marcelle Chauvet. 2009. How Better Monetary Statistics Could Have Signaled the Systemic Risk Precipitating the Financial Crisis. Journal of Econometrics, forthcoming.

Barnett, William A., John Keating, and Logan J. Kelly. 2008. Toward a Bias Corrected Currency Equivalent Index. Economics Letters 100:448-451.

Barnett, William A., and Apostolos Serletis, eds. 2000. The theory of monetary aggregation. Contributions to Economic Analysis, vol. 245: Amsterdam: Elsevier.

Bernanke, Ben S., Jean Boivin, and Piotr Eliasz. 2005. Measuring the Effects of Monetary Policy: A Factor-Augmented Vector Autoregressive (FAVAR) Approach. Quarterly Journal of Economics 120 (1):387 - 422.

Christiano, Lawrence J. 1991. Modeling the Liquidity Effect of a Money Shock. Federal Reserve Bank of Minneapolis Quarterly Review 15 (1):3 - 34.

Christiano, Lawrence J., Martin Eichenbaum, and Charles Evans. 1996. The Effects of Monetary Policy Shocks: Evidence from the Flow of Funds. Review of Economics and Statistics 78 (1):16 - 34.

Cochrane, John H. 1989. The Return of the Liquidity Effect: A Study of the Short-run Relation between Money Growth and Interest Rates. Journal of Business and Economic Statistics 7 (1):75 - 83.

Dutkowsky, Donald H., and Barry Z. Cynamon. 2003. Sweep Programs: The Fall of M1 and Rebirth of the Medium of Exchange. Journal of Money, Credit, and Banking 35 (2):263 - 279.

Eichenbaum, Martin, and Charles L. Evans. 1995. Some Empirical Evidence on the Effects of Shocks to Monetary Policy on Exchange Rates. Quarterly Journal of Economics 110 (4):975 - 1009.

Hamilton, James D. 1997. Measuring the Liquidity Effect. American Economic Review 87 (1):80 - 97.

Hutt, William H. 1963. Keynesianism - Retrospect and Prospect: Chicago: Regnery.

Keen, Benjamin D. 2004. In search of the liquidity effect in a modern monetary model. Journal of Monetary Economics 51 (7):1467-1494.

Kelly, Logan J. 2009. The Stock of Money and Why You should Care. Advances in Econometrics: Measurement Error - Econometrics and Practice. Volume 24. Jane Binner, David Edgerton, and Thomas Elger (Eds.).

———. 2010. The Current Stock of Money: An Aggregation Theoretic Measure of Narrowly Defined Money. Applied Economics Letters. Forthcoming.

Leeper, Eric M., and David B. Gordon. 1992. In Search of the Liquidity Effect. Journal of Monetary Economics 29 (3):341 - 369.

Litterman, Robert B., and Laurence M. Weiss. 1985. Money, Real Interest Rates, and Output: A Reinterpretation of Postwar U.S. Data. Econometrica 53: 129-156.

Melvin, Michael. 1983. The Vanishing Liquidity Effect of Money on Interest: Analysis and Implications for Policy. Economic Inquiry 21 (2):188 - 202.

Mishkin, Frederic S. 1982. Monetary Policy and Short-Term Interest Rates: An Efficient Markets-Rational Expectations Approach. Journal of Finance 37 (1):63-72.

Pesaran, H. Hashem, and Yongcheol Shin. 1998. Generalized impulse response analysis in linear multivariate models. Economics Letters 58 (1):17-29.

Reichenstein, William. 1987. The Impact of Money on Short-term Interest Rates. Economic Inquiry 25 (1):67-82.

Rotemberg, Julio J, John C Driscoll, and James M Poterba. 1995. Money, Output, and Prices: Evidence from a New Monetary Aggregate. Journal of Business and Economic Statistics 13 (1):67-83.

Serletis, Apostolos, and Victor Chwee. 1997. Resolving the Liquidity Puzzle. Macroeconomic Dynamics 1 (4):720 - 739.

Sims, Christopher A. 1980. Comparison of Interwar and Postwar Business Cycles: Monetarism Reconsidered. American Economic Review 70 (2):250 - 257.

———. 1992. Interpreting the Macroeconomic Time Series Facts: The Effects of Monetary Policy. European Economic Review 36 (5):975 - 1000.

Strongin, Steven. 1995. The Identification of Monetary Policy Disturbances: Explaining the Liquidity Puzzle. Journal of Monetary Economics 35 (3):463 - 497.