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Liquidity Effects, Monetary Policy, and the Business Cycle

51 Pages Posted: 9 Jun 2004  

Martin Eichenbaum

Northwestern University; National Bureau of Economic Research (NBER)

Lawrence J. Christiano

Northwestern University; Federal Reserve Bank of Cleveland; Federal Reserve Bank of Chicago; Federal Reserve Bank of Minneapolis; National Bureau of Economic Research (NBER)

Date Written: August 1992

Abstract

This paper presents new empirical evidence to support the hypothesis that positive money supply shocks drive short-term interest rates down. We then present a quantitative, general equilibrium model which is consistent with the hypothesis. The two key features of our model are that (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. Together, these imply that, in our model, a positive money supply shock generates a large drop in the interest rate comparable in magnitude to what we find in the data. In sharp contrast to sticky nominal wage models, our model implies that positive money supply shocks lead to increases in the real wage. We report evidence that this is consistent with the U.S. data. Finally, we show that our model can rationalize a version of the Real Bills Doctrine in which the monetary authority accommodates technology shocks, thereby smoothing interest rates.

Suggested Citation

Eichenbaum, Martin and Christiano, Lawrence J., Liquidity Effects, Monetary Policy, and the Business Cycle (August 1992). NBER Working Paper No. w4129. Available at SSRN: https://ssrn.com/abstract=226811

Martin Eichenbaum (Contact Author)

Northwestern University ( email )

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National Bureau of Economic Research (NBER)

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Lawrence J. Christiano

Northwestern University ( email )

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Evanston, IL 60208
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847-491-7001 (Fax)

Federal Reserve Bank of Cleveland

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Federal Reserve Bank of Chicago

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Federal Reserve Bank of Minneapolis

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National Bureau of Economic Research (NBER)

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