Federal Reserve Bank of St. Louis Review

One of the most pervasive real effects long-claimed for monetary policy is its ability to affect interest rates in the short run through channels other than the standardexpected inflation effect. The alleged short­ term inverse relationship between interest rates and monetary policy is often called the “liquidity effect” of monetary policy. We use the term liquidity effect to refer to the pur­ ported statistical relation between expansion of bank reserves or monetary aggregates (or perhaps only surprise expansions of these aggregates) and short-run reductions in short-term interest rates. The liquidity effect can also refer to the common interpretation of this purported statistical relation: that the same central bank action that changes bank reserves or monetary aggregates also changes short-term interest rates. This definition corresponds to early use of the term, for example, by Friedman in 1968.1 We distinguish between a nominal liquidity effect (the aforementioned relation with a nominal interest rate) and a real liquidity effect (the aforementioned relation with a real interest rate). Either may occur without the other. For many purposes, real liquidity effects are more interesting because they indicate real effects of monetary policy. On the other hand, central banks around the world claim that their operating procedures directly target or control nominal interest rates— that they reduce reserves of the banking system (perhaps through open market sales) to raise the nominal interest rate or raise reserves of the banking system (perhaps through open market purchases) to reduce the nominal interest rate. It is difficult to interpret these claims without a coherent model of nominal liquidity effects. The monetary policies that the Federal Reserve claims that it follows require the existence of liquidity effects. Many central bank operating procedures that involve use of the federal funds rate (or any other interest rate) as a target, instrument, or operating variable of monetary policy require a liquidity effect. The current operating procedure of the Federal Reserve is predicated on the exis­ tence of a liquidity effect in the sense that the Fed uses the federal funds rate as its proximate instrument of policy and contracts quantities of reserves and monetary aggregates by raising the funds rate (and vice versa). W hen the Fed raises the federal funds rate, it reduces reserves by the amount sufficient to achieve the desired increase. The smaller the required reduction in reserves, the larger the implied nominal liquidity effect. Of course, a central bank operating procedure that attempts only to tie down the nominal interest rate (which ties down the real inter­ est rate plus the expected rate of change of the price level) may lack a nominal anchor to tie down the level of prices. If, however, the operating procedure also includes a pro­ vision to revert to control over the level of monetary aggregates if inflation exceeds some critical level, then the price level may be anchored at least within a certain range. Attempts to isolate liquidity effects empirically are often subject to a unique problem: If the central bank operating proce­ dure involves direct targeting of a short-term interest rate, statistical work and economic models that treat a monetary aggregate as exogenous and the nominal interest rate as endogenous may be misleading. This has led many economists to question the exis­ tence of liquidity effects. Although we do not attempt to resolve that issue in this article, we note that other kinds of evidence (that do not involve regressions of interest rates on allegedly exogenous monetary aggregates) suggest important liquidity effects in the 1 Some economists use the term dif­ ferently, viz. to refer to a particular class of theoretical models attempting to explain the purported relation.