No abstract

Deteriorating economic conditions in late 2008 led the Federal Reserve to lower the target federal funds rate to near zero, inject liquidity through novel facilities, and engage in large‐scale asset purchases. The combination of conventional and unconventional policy measures prevents using the effective federal funds rate to assess the effects of monetary policy beyond 2008. We employ a broad monetary aggregate to elicit the effects of monetary policy shocks both before and after 2008. Our estimates align well with major changes in the Fed's asset purchase programs and yield responses that are free from price, output, and liquidity puzzles that plague other approaches.

Measuring the economic stock of money, de ned to be the present value of current and future monetary service ows, is a di cult asset pricing problem, because most monetary assets yield interest. Thus, an interest yielding monetary asset is a joint product: a durable good providing a monetary service ow and a nancial asset yielding a return. The currency equilivant index provides an elegant solution, but it does so by making strong assumptions about expectations of future monetary service ows. These assumptions cause the currency equivalent index to exhibit signi cant downward bias. In this paper, we propose an extension to the currency equivalent index that will correct for a signi cant amount of this bias.

In this paper, I will examine the problems created by incorrectly using a simple sum monetary aggregate to measure the monetary stock. Specically, I will show that simple sum monetary aggregate confounds the current stock of money with the investment stock of money and that this confounding leads the simple sum monetary aggregate to report an articially smooth monetary stock. This smoothing causes important information about the dynamic movements of the monetary stock to be lost. This may oer at least a partial explanation of why so many studies nd that money has little economic relevance. To that end, we will conclude the paper by examining a reduced form backward looking IS equation to determine whether monetary aggregates contain information about real GDP gap. This paper diers from previous work in that it focuses on smoothing of the monetary stock data caused by the use of simple sum methodology, where the previous work focuses on the bias exhibited by simple sum monetary aggregates.

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.