The Impact of Money on Short‐term Interest Rates

Abstract

This study reviews empirical evidence from four research methods related to the impact of money on short-term nominalrates. The studies consistently fail to find evidence supporting the much hypothesized short-term, negative relationship between money and nominal rates since at least April 1975. Reasons for the absence of a negative relationship include the tendency of financial markets to anticipate corrective action by the Fed whenever M1 deviates from targeted growth ranges and a rapid adjustment of inflationary expectations to changes in money growth.There is a general perception that the Federal Reserve can significantly lower short-term interest rates, at least for a while, by increasing the growth rate of money. In a review of studies on this issue from four research methods, this paper finds no consistent empirical evidence (since at least April 1975) to support this negative relationship between money and interest rates. The four research methods include two families of interest rate models and two rational expectation-efficient market models. I. ECONOMIC THEORYThe theoretical effect of a monetary acceleration can be examined in the Hicksian IS-LM framework. Assume the Fed permanently accelerates money growth and that prices, output, and inflation are not immediately affected.The acceleration shifts the LM curve, increases real balances, and reduces nominal and real interest rates. This is the liquidity effect.The combination of lower real rates and higher real balances stimulates spending, which leads to an increase in nominal income. This is the income effect; it increases the demand for money and increases nominal rates.Monetary acceleration also has an impact on inflationary expectations. Increased inflationary expectations raise the IS curve, causing an increase in nominal rates.Key to the popular argument that the Fed can lower nominal rates at least for a while through a monetary acceleration are three assumptions: that prices do not adjust immediately to the new money supply, and that inflationary expectations and money demand are not affected quickly by changes in money. It is clear from the literature that these assumptions have been widely *Associate Professor, North Texas State University. The author wishes to thank J. Walter Elliott, Gary J. Santoni, Richard J. Sweeney, and two anonymous referees for valuable comments on earlier drafts. 67 Economic Inquiry Vol. XXV, January 1987, 67-82 1. The market response is not dependent upon a quantitatively measureable short-run, negative relationship between money and rates. It is dependent upon the expectation that such an effect exists. The strength of the response should adjust over time with expectations. 2. K. M. Carlson [1980] and Friedman [1984] present evidence that the lags between money and prices and money and income have shortened. 3. Friedman [1980] recently argued that money affects inflationary expectations within a month or two.

The monetary transmission mechanism in Brazil: evidence from a var analysis

“…The first one usually identifies the monetary policy shocks as innovations to some monetary aggregate, the monetary base, the money stock or M2 [Barro (1977), Reichenstein (1987), Cochrane (1994)]. The second trend, interprets policy shocks as innovations to the baseline interest rate [Bernanke and Gertler (1995), Bernanke and Blinder (1992), Evans (1994, 1999)].…”

“…The applied literature on the monetary transmission mechanism mostly analyses the American case and European countries, identifying the actions of the monetary authority as a shock to either some monetary aggregate [Barro (1977), Reichenstein (1987), Cochrane (1994)] or to the baseline interest rate [Bernanke and Gertler (1995), Bernanke and Blinder (1992), Evans (1994, 1999), Peerman and Smets (2001)]. For the Brazilian case, Mendonça (2001) discusses the monetary and lending channels of monetary policy and provides an application of the Taylor's rule to the determination of the interest rate after 1999.…”

Uncertain identification

“…21 The price puzzle occurs when contractionary monetary policy shocks produce a positive response of the price level (Sims, 1992). The liquidity puzzle refers to shocks in monetary aggregates leading to an initial rising rather than falling of interest rates (Reichenstein, 1987).…”

“…Second, if the point-identified model can be considered a reasonable benchmark, the method offers a simple and flexible way to add non-dogmatic identifying information to the set-identified model, which results in increasing informativeness of the conclusions in a transparent manner. Third, the method can be used to perform reverse engineering exercises that compute the prior probability one would need to attach to a set of identifying assumptions in order for the averaging to preserve a given empirical conclusion (e.g., the so-called price and liquidity puzzles in monetary SVARs, respectively discussed by (Sims, 1992) and (Reichenstein, 1987)). …”

Retrieving the vanishing liquidity effect—a threshold vector autoregressive model

“…For instance, using a sample period from 1973-1979, Melvin (1983 showed that, by the second month, the interest rate rose sharply above the initial rate after an increase in monetary growth. Similarly, using a sample period of quarterly data covering 1975data covering :4 -1983data covering :3, Mishkin (1981data covering , 1982 and Reichenstein (1987) also failed to find evidence supporting a short-term liquidity effect. Mehra (1985), in a study using data from both low and high inflation periods, found that a liquidity effect occurred in the 1950s and early 1960s, but this effect had all but disappeared in the subperiod beginning in the 1970s and ending in 1979.…”