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Modeling the Liquidity Effect of a Money Shock

Quarterly Review 1511 | Winter 1991

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Modeling the Liquidity Effect of a Money Shock


There is widespread agreement that a surprise increase in an economy's money supply drives the nominal interest rate down and economic activity up, at least in the short run. This is understood as reflecting the dominance of the liquidity effect of a money shock over an opposing force, the anticipated inflation effect. This paper illustrates why standard general equilibrium models have trouble replicating the dominant liquidity effect. It also studies several factors which have the potential to improve the performance of these models.

Published In: _The Rational Expectations Revolution: Readings from the Front Line_ (1994, pp. 427-482)