The Puzzling Effect Of Money Shocks On Interest Rates

Abstract

This study reexamines the controversial impact of changes in the growth rate of money supply on short-term nominal interest rates. Most of the early studies consistently find evidence that support a negative relationship between money shocks and interest rates. This relationship reflects the hypothesized liquidity effect. When the Fed accelerates the growth rate in money supply at given prices, output and inflation, the LM curve shifts, and real balances increase. Consequently, nominal an real interest rates are reduced. The results of the finite lag methods vary from one technique to another. However, the general trend points toward the vanishing liquidity effect. An infinite lag method which assumes a quadratic polynomial lag structure is also applied to data from 1972 through 1989. The results show a slight presence of the liquidity effect. The overall results also indicate that inflation rate as well as the variance of inflation rate slightly influence the relationship described above.