Rethinking the liquidity puzzle: Application of a new measure of the economic money stock

Abstract

Historically, attempts to solve the liquidity puzzle have focused on narrowly defined monetary aggregates, such as non-borrowed reserves, the monetary base, or M1. Many of these efforts have failed to find a short-term negative correlation between interest rates and monetary policy innovations. More recent research uses sophisticated macroeconomic and econometric modeling. However, little research has investigated the role measurement error plays in the liquidity puzzle, since in nearly every case, work investigating the liquidity puzzle has used one of the official monetary aggregates, which have been shown to exhibit significant measurement error. This paper examines the role that measurement error plays in the liquidity puzzle by (i) providing a theoretical framework explaining how the official simple-sum methodology can lead to a liquidity puzzle, and (ii) testing for the liquidity effect by estimating an unrestricted VAR.

Wavelet Multiresolution Analysis of the Liquidity Effect and Monetary Neutrality

“…Several attempts to solve the liquidity puzzle include, inter alia, using nonborrowed reserves as an indicator for monetary policy (Eichenbaum 1992), extending the federal-funds VAR by including a proxy for the Fed's information about inflation (Sims 1992), considering non-borrowed monetary base shocks (Serletis and Chwee 1997), and using the federal-funds rate as an indicator of monetary policy actions (Bernanke and Blinder 1992). In this line of research, Kelly et al (2011) argue that the liquidity puzzle is due to measurement errors in narrowly defined monetary aggregates. Kelly et al then empirically find that the broadest monetary aggregate exhibits stronger liquidity effects.…”

The Quantity Theory Revisited: A New Structural Approach

“…Kelly (2009) showed that this confounding causes simple-sum aggregates to fail to capture the true relationship between the economic money stock and interest rates. Finally, Kelly, Barnett, and Keating (2011) argues that much of the liquidity puzzle can be explained by the measurement error exhibited by simple-sum aggregation.…”

“…Conventional wisdom suggests that using a sufficiently narrow monetary aggregate is necessary to avoid the many empirical puzzles that have plagued monetary economists; however, Kelly, Barnett, and Keating (2011) finds that when money is measured using a reputable index number, a broad monetary aggregate exhibits empirical results that are more consistent with theoretical expectations than do narrow aggregates.…”

“…These problems can only be addressed by carefully measuring money using 1 This includes the seminal contributions of Gordon and Leeper (1994), Leeper, Sims, and Zha (1996) Bernanke andMihov (1998), Christiano, Eichenbaum, andEvans (1996) and Christiano, Eichenbaum, and Evans (1999). 2 See, e.g., Barnett and Serletis (2000), Barnett, Chae, and Keating (2005), Barnett, Keating, and Kelly (2008), Barnett and Chauvet (2011), Kelly (2009), and Kelly, Barnett, and Keating (2011 The remainder of the paper is structured as follows. Since the use of Divisa money is quite unusual in this literature, sections two and three will start by introducing the dataset and giving a brief descriptive analysis of the core developments.…”

The future of universal banking

“…''Rethinking the liquidity puzzle: Application of a measure of the economic money stock,' ' Kelly, Barnett and Keating (2011) provides a reconsideration of the potential solutions to the liquidity puzzle. They argue that historically attempts to solve this puzzle have focused on narrowly defined monetary aggregates, such as non-borrowed reserves, the monetary base, or M1.…”