Identification and the Liquidity Effect of a Monetary Policy Shock

Conventional wisdom holds that unanticipated expansionary monetary policy shocks cause transient but persistent decreases in real and nominal interest rates. However a number of econometric studies argue that the evidence favors the opposite view, namely that these shocks actually raise, rather than lower, short term interest rates. We show that this conclusion is not robust to the measure of monetary aggregate used or to the assumptions made to identify monetary policy disturbances. For example, when our analysis is done using non borrowed reserves, we find strong evidence in favor of the conventional view. Existing challenges to the conventional view lack credibility not just because of their fragility. They are based upon measures of policy disturbances which generate seemingly implausible implications about things other than interest rates.