Rethinking the liquidity puzzle: Application of a new measure of the economic money stock

Historically, attempts to solve the liquidity puzzle focus on narrowly defined monetary aggregates, such as non-borrowed reserves, the monetary base, or M1. Many of these efforts fail to find a short-term negative correlation between interest rates and monetary policy innovations. More recent resear...

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Bibliographic Details
Published in:Journal of banking & finance 2011-04, Vol.35 (4), p.768-774
Main Authors: Kelly, Logan J., Barnett, William A., Keating, John W.
Format: Article
Language:English
Subjects:
Divisia index numbers
Econometric models
Econometrics
Error
Federal Reserve monetary policy
Interest rates
Liquidity
Liquidity puzzle
Liquidity puzzle Monetary policy Monetary aggregation Money stock Divisia index numbers
Macroeconomics
Measurement
Measurement errors
Monetary aggregation
Monetary policy
Money stock
Money supply
Studies
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Summary:Historically, attempts to solve the liquidity puzzle focus on narrowly defined monetary aggregates, such as non-borrowed reserves, the monetary base, or M1. Many of these efforts fail 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. In this paper, we examine 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.
ISSN:0378-4266
1872-6372
DOI:10.1016/j.jbankfin.2010.10.019