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Banks, bonds, and the liquidity effect

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  • Tor Einarsson
  • Milton H. Marquis

Abstract

An \"easing\" of monetary policy can be characterized by an expansion of bank reserves and a persistent decline in the federal funds rate that, with a considerable lag, induces a pickup in employment, output, and prices. This article presents empirical evidence consistent with this depiction of the dynamic response of the economy to monetary policy actions and develops a theoretical model that exhibits similar dynamic properties. The decline in the federal funds rate is referred to as the \"liquidity effect\" of an expansionary monetary policy. A key feature of this class of theoretical models is the restriction that households do not quickly adjust their liquid asset holdings, in particular their bank deposit position, in response to an unanticipated change in monetary policy. Without this restriction, there would be no liquidity effect, as interest rates would rise rather than fall in response to an easing of monetary policy due to higher anticipated inflation. A bond market that enables households to lend directly to firms is shown to provide a mechanism that induces persistence in the liquidity effect that is otherwise absent from the predictions of the model.

Suggested Citation

  • Tor Einarsson & Milton H. Marquis, 2002. "Banks, bonds, and the liquidity effect," Economic Review, Federal Reserve Bank of San Francisco, pages 35-50.
    • Handle: RePEc:fip:fedfer:y:2002:p:35-50
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    References listed on IDEAS

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    1. Tor Einarsson & Milton H. Marquis, 2000. "Bank intermediation and persistent liquidity effects in the presence of a frictionless bond market," Working Paper Series 2000-08, Federal Reserve Bank of San Francisco.
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    Cited by:

    1. Chen, Shu-Hua, 2015. "Macroeconomic (In)Stability Of Interest Rate Rules In A Model With Banking System And Reserve Markets," Macroeconomic Dynamics, Cambridge University Press, vol. 19(7), pages 1476-1508, October.
    2. Max Gillman & Mark N Harris & Michal Kejak, 2007. "The Interaction of Inflation and Financial Development with Endogenous Growth," Money Macro and Finance (MMF) Research Group Conference 2006 29, Money Macro and Finance Research Group.

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