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May/June 1995, 
Vol. 77, No. 3
Posted 1995-05-01

Theoretical Issues of Liquidity Effects

by Lee E. Ohanian and Alan C. Stockman

The authors define the liquidity effect as “the purported statistical relation between expansion of bank reserves or a monetary aggregate and short-run reductions in short-term interest rates.” They then explore the liquidity effect in general equilibrium, representative-agent models. Their analysis shows that in a general-equilibrium environment, exogenous changes in money can, in principle, affect real output, prices or the interest rate. If money is neutral and prices adjust instantaneously, monetary policy changes the price level, but not output or the real interest rate. If prices do not adjust instantaneously, a liquidity effect occurs—the real interest rate declines in response to a monetary expansion. The failure of the price level to adjust immediately to its new long-run equilibrium, however, also produces expectations of inflation. From the Fisher relation, the nominal interest rate may either rise or fall, depending on the relative size of the liquidity and price expectations effects. If the liquidity effect is dominant, both the nominal and real rates fall. If the price expectations effect is dominant, the nominal rate rises. The authors show that within this class of models, variants differ both in the mechanisms that produce sluggish price adjustments and in how monetary policy actions influence the real economy. Their review considers a wide variety of equilibrium models: one- and two-sector sticky-price models, two-country models, limited-participation models (with and without representative agents), and even models where the only role for money is to reduce intermediation costs. In the last case, the liquidity effect is perverse: An increase in the money supply causes the real interest rate to rise because a monetary innovation represents a technological change.