Liquidity Effects, Monetary Policy, and the Business Cycle

By Christiano, Lawrence J.; Eichenbaum, <artin | Journal of Money, Credit & Banking, November 1995 | Go to article overview

Liquidity Effects, Monetary Policy, and the Business Cycle


Christiano, Lawrence J., Eichenbaum,

This paper presents a flexible-price, quantitative general equilibrium model with the property that a positive money supply shock drives the nominal interest rate down, and aggregate employment, output, and the real wage up. These implications are broadly consistent with postwar U.S. data. I The two key features of the model that are responsible for its properties are (i) money shocks have a heterogeneous impact on agents and (ii) ex post inflexibilities in production give rise to a very low short-run interest elasticity of money demand. In our model, the extent of the drop in the interest rate after a positive money supply shock depends on the degree to which production is ex post inflexible. Given sufficient ex post inflexibility, the model conforms well with the view, widely held within the U.S. Federal Reserve System, that the short-run interest rate elasticity for total reserves is very close to zero (see Strongin 1992).

The implications of our model stand in contrast to those generated by existing quantitative general equilibrium monetary business cycle models. For example, King (1992) discusses the difficulty of reconciling sticky-wage and sticky-price models with the view that positive money supply shocks drive the interest rate down. Modified real business cycle (RBC) models where money is introduced simply via cash-in-advance constraints (Greenwood and Huffman 1987, Cooley and Hansen 1989, or Christiano 1991) or a transactions role for cash (den Haan 1991 or Marshall 1992) are also inconsistent with this view. In these models, if the growth rate of money displays positive persistence, then an unanticipated positive shock to the growth rate of money drives the nominal interest rate up, but employment and output down. This is because, in these types of theories, money shocks affect interest rates exclusively through an anticipated inflation effect. The only way for an exogenous shock to the money supply to drive the interest rate down in these models is for the shock to signal a subsequent decline in money growth. This requires grossly counterfactual assumptions regarding the law of motion for the money supply.

So, an important challenge is to identify features of the economy that account for the negative response of short-term interest rates to money supply shocks. In section I of this paper we present a model that allows us to explore the quantitative importance of two such frictions. The first is a friction in the household saving decision, which has the implication that money injections have a heterogeneous impact on agents. The second friction is an inflexibility in the production process. In stressing heterogeneity, we are following a tradition of theoretical papers that argue that the key to understanding the nonneutrality of money supply shocks is that they impact differently on different agents (Grossman and Weiss 1983; Rotemberg 1984; Woodford 1987; Baxter et al. 1990). This paper follows Lucas (1990) and Fuerst (1992) in supposing that firms are the agents who absorb a disproportionately large share of money supply shocks. To generate this result we suppose, as do Lucas and Fuerst, that (i) changes in the money supply initially involve the monetary authority and financial sector only, and (ii) the representative household's supply of funds to the financial sector is predetermined relative to monetary shocks. Under these circumstances, firms are forced to absorb a disproportionate share of an unanticipated money injection. In our model this is sufficient to guarantee that the equilibrium rate of interest falls after a positive shock to the money supply.

How much does the interest rate fall? In our model the answer depends on the marginal product of working capital to firms. This in turn depends on the extent to which production is ex post flexible. Specifically, we assume that money shocks occur at a time when firms have already precommited themselves to particular production plans, and that these are difficult to adjust once initiated. …

The rest of this article is only available to active members of Questia

Already a member? Log in now.

Notes for this article

Add a new note
If you are trying to select text to create highlights or citations, remember that you must now click or tap on the first word, and then click or tap on the last word.
One moment ...
Default project is now your active project.
Project items

Items saved from this article

This article has been saved
Highlights (0)
Some of your highlights are legacy items.

Highlights saved before July 30, 2012 will not be displayed on their respective source pages.

You can easily re-create the highlights by opening the book page or article, selecting the text, and clicking “Highlight.”

Citations (0)
Some of your citations are legacy items.

Any citation created before July 30, 2012 will labeled as a “Cited page.” New citations will be saved as cited passages, pages or articles.

We also added the ability to view new citations from your projects or the book or article where you created them.

Notes (0)
Bookmarks (0)

You have no saved items from this article

Project items include:
  • Saved book/article
  • Highlights
  • Quotes/citations
  • Notes
  • Bookmarks
Notes
Cite this article

Cited article

Style
Citations are available only to our active members.
Buy instant access to cite pages or passages in MLA, APA and Chicago citation styles.

(Einhorn, 1992, p. 25)

(Einhorn 25)

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited article

Liquidity Effects, Monetary Policy, and the Business Cycle
Settings

Settings

Typeface
Text size Smaller Larger Reset View mode
Search within

Search within this article

Look up

Look up a word

  • Dictionary
  • Thesaurus
Please submit a word or phrase above.
Print this page

Print this page

Why can't I print more than one page at a time?

Help
Full screen

matching results for page

    Questia reader help

    How to highlight and cite specific passages

    1. Click or tap the first word you want to select.
    2. Click or tap the last word you want to select, and you’ll see everything in between get selected.
    3. You’ll then get a menu of options like creating a highlight or a citation from that passage of text.

    OK, got it!

    Cited passage

    Style
    Citations are available only to our active members.
    Buy instant access to cite pages or passages in MLA, APA and Chicago citation styles.

    "Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn, 1992, p. 25).

    "Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn 25)

    "Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences."1

    1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

    Cited passage

    Thanks for trying Questia!

    Please continue trying out our research tools, but please note, full functionality is available only to our active members.

    Your work will be lost once you leave this Web page.

    Buy instant access to save your work.

    Already a member? Log in now.

    Author Advanced search

    Oops!

    An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.