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May/June 1988, 
Vol. 70, No. 3
Posted 1988-05-01

The Effect of Monetary Policy on Short-Term Interest Rates

by Daniel L. Thornton

Daniel L. Thornton investigates the responsiveness of interest rates to changes in monetary policy. Analysts often argue, Thornton notes, that changes in monetary policy initially affect the economy through a “liquidity effect” on interest rates. For example, an expansionary monetary policy is said to depress market interest rates initially. Applying three reduced-form methodologies commonly found in the literature to the same monthly data set, the author finds no evidence of a strong, statistically significant, inverse relationship between monetary changes and interest rates. He finds that the strongest and most consistent negative relationship is between interest rates and nonborrowed reserves. Even in this case, however, the effect is weak and short-lived.