NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Liquidity Effects, Monetary Policy, and the Business Cycle

Martin Eichenbaum, Lawrence J. Christiano

NBER Working Paper No. 4129
Issued in August 1992
NBER Program(s):   ME

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.

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Document Object Identifier (DOI): 10.3386/w4129

Published: Journal of Money, Credit and Banking, vol. 27, no. 4, November 1995 Part I pp 1113-1136

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