THE VANISHING LIQUIDITY EFFECT OF MONEY ON INTEREST ANALYSIS AND IMPLICATIONS FOR POLICY

MICHAEL MELVIN’

This paper seeks to re-examine the effects of money on interest rates. The earlier literature on this topic determined, fairly well, the pattern of response of interest rates to changes in money growth. The notable studies of Cagan (1972), Cagan and Gandolfi (1969), and Gibson (1970) served to establish the profession’s “stylized pattern” as presented in section I . Section II presents new evidence on the subject and finds that the old empirical generalizations no longer hold. Specifically, the results suggest that the initial liquidity effect of faster money growth is likely to be offset within the month following the monetary policy change. Sections III and IV investigate the reasons for the changing pattern of monetary effects on interest rates and discuss the policy implications of the new pattern.

I. EXPECTED PATTERN

Changes in the growth rate of money are expected to affect nominal interest rates in different ways over time. When the growth rate of money increases, initially there is an excess supply of money at the existing income, interest rate, and price level. Since prices and income are somewhat slow to change, we expect the interest rate to fall to equate money demand and money supply. This initial fall in nominal (and real) interest rates is known as the liquidity effect. In addition to the liquidity effect depressing the interest rate, there also exists a credit or financial effect. When the growth rate of money increases, excess reserves of banks also increase. Banks use short-term marketable securities to adjust to changes in their reserves in the short- run, and only adjust their loan portfolios over time. Thus as money growth increases, the financial effect will lead banks to purchase securities and thereby lower the rate of interest in response to the increase in excess reserves. Over time, as loan portfolios adjust, the demand for marketable securities falls which tends to increase the interest rate. Thus the time pattern of the financial effect suggests a decline and later rise in interest rates following an increase in money growth.

Nominal income will eventually rise following the increased growth rate of money (due to a higher price level as well as short-run increases in real income).

*Arizona State University. Thanks are due John Chant, Herb Kaufman, and two anonymous referees

1. Gibson (1970) pointed out that the rise in real income is due to the initial fall in interest rates caused for commenting on an earlier draft of this paper.

by the higher money growth rate:

Once the money stock has been increased and interest rates fall, rates of return on capital goods will be farther above market rates than before, and more capital goods will tend to be produced. The production of these additional capital goods raises income directly and prob- ably also indirectly via multiplier effects (p. 289).

Then as income rises, money demand will increase lending to higher interest rates, or in Gibson’s words:

Whereas the liquidity effect corresponded to a downward movement along a fixed demand curve for nominal balances, the income effect results from an outward shift as income increases (p. 289).

Economic Inquiry Vol. XXI, April 1983

188

MELVIN: T H E VANISIIINC. LIQUIDITY EFFECT 1x9

This increased nominal income will increase spending and money demand, which in turn leads to higher interest rates. This income effect on interest rates explains why Cagan and Gandolfi looked at the monetary effects on interest rates to infer the lag in the effect of money on income. However the financial effect could lead to a rise in interest rates before any income effects occur [see Darby (1975)], so that it may, in fact, be preferable to look directly at money and income rather than go through interest rates to determine the lag in the effect of monetary policy on income.

Finally, there is a Fisher or expectations effect as the nominal interest rate increases due to a change in expected inflation. If inflation has no effect on the real rate of interest in the steady state, then the rise in nominal rates must be proportional to the increase in expected inflation.2

The expected pattern of interest rates following an increase in money growth at time t * is illustrated in figure 1. In terms of the effects discussed above, region A reflects the operation of the liquidity effect; the income effect occurs in B, while the financial effect is active in both A and B. Region C reflects the expectations effect as the nominal interest rate increases due to the anticipation of a higher future inflation rate.

FIGURE 1

Stylized Lag Distribution of Monetary Effects on Interest Rates

The empirical evidence given in the studies cited above corresponds closely to the stylized pattern of figure 1. In this sense, the general pattern of response is consid- ered to be a settled issue among most monetary economists [see Brown and Santoni (1982) and Darby (1979), for instance] and the area of particular interest in this paper is the timing of the response.

II. NEW EVIDENCE

The basic equation of interest is:

2. The real rate could, of course, be changed in equilibrium if real savings or the aggregate production function are changed [see Mundell (1963)l.

190 ECONOMIC INQUIRY

Points 80- 78- 76. 74- 72. 70. 68.

where i is the interest rate, gM is the growth rate of money, and A is the first difference operator. Cagan and Gandolfi found that the interest rate declines for six months following an increase in money growth and then begins to rise. Gibson found results very similar to Cagan and Gandolfi. Depending upon the definitions of money and interest rates used, he found that the initial negative effects on the inter- est rate began to be reversed starting four to nine months later.

Both the Cagan and Gandolfi and Gibson articles presented estimates of (1) over the post-war period to the mid-1960’s. Using monthly data on the four to six month commercial paper rate and the M , definition of money (the variables used by the

FIGURE 2

The Effect of Changes in Money Growth on Interest Rates 36 month unconstrained lags

1973 to

i lg7’

I

0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 36

Months

MELVIN: THE VANISIIING 1,IQUIDITY EFFECT 191

previous authors), equation (1) was first estimated over the 1951-79 period, and then over three sub- period^.^ Figure 2 illustrates the cumulative sums of the coefficients of equation (1) using a lag distributed over 36 months, while figure 3 shows the lag pattern over 12 months. The coefficient units are in terms of basis points per one percentage point change in the annual rate of money growth. Tables 1 and 2 present information on the individual lag coefficients.

The estimate for the 1951-65 period as shown in figure 2, is, as expected, quite similar to the earlier findings cited above, including the stylized pattern of figure 1. This result reflects the fact that the stylized pattern was shaped by the now classic studies of Cagan, Cagan and Gandolfi, and Gibson. The time patterns plotted for 1951-65,1951-79, and 1966-79 by the three lower lines of figure 2 show the familiar tendency for interest rates to at first fall and then rise following an increase in the growth rate of money. The late, 1973-79, estimate indicates a substantial change in the pattern of response of interest rates to changes in money growth. Note that when the 1951-79 period is split into 1951-65 and 1966-79, the estimates of (1) are still quite similar. An F test for equality of coefficients over the 1951-65, 1966-79 sub-periods yields the calculated F statistic of .79, while FU5,38,2i2 is approximately 1.4. Thus splitting the sample at 1966 indicates no significant change in the relationship between money and interest rates. One may then infer from the three lower lines of figure 2, that following an increase in money growth, interest rates would tend to fall for two to five months before starting to rise and would tend to remain below the initial rate for a period of six to twelve months.

A startling contrast appears if the sample is broken at 1973.4 Over the recent 1973-79 period, the liquidity effect has been much shorter lived, as the immediate drop in interest rates following an increase in money growth rates started to be offset within the month following the change in monetary policy. By the second month after the change in money growth, interest rates were sharply above the initial rate. Testing the equality of coefficients over the two sub-samples 1951-72 and 1973-79, the computed F statistic is 3.71, which is a significant value of F with degrees of freedom 38,272. Thus we conclude that a significant change occurred in the response of interest rates to money growth over the last sample period.

One curious result for the 1973-79 period is the drop in rates occurring around the eighth month which continues for nine months before rates rise steeply again. A recent article by Stokes and Neuburger (1979), applying Box-Jenkins transfer func- tions to estimate the lagged effects of money on interest over the 1947-78 period, also finds the dip in interest rates around a year after the increase in money growth. The fact that this effect was not observed in the early period results leads to the question

3. The data were taken from the CITIBASE data tape. Since the data on old M , are no longer updated, the sample can only extend through 1979. While monthly data for the new definition of M , only extend back to 1959, estimates using a shortened sample from 1959-80 were qualitatively the same as the longer period estimates presented here. Since one goal of this paper is to contrast the current findings with previous studies, it is desirable to be able to use data back to the early 19505, as this includes the period covered by the previous authors.

4. A break at January, 1973 splits the 1966-79 period roughly in half. While one could search for alternative dates where there is a significant change in structure (using cusum-squares tests or repeated Chow tests), the exact date of such change is not important here. The present paper simply wishes to establish that a change in structure did occur in order to motivate the discussion below. It should be noted that the period under study contained several potentially important events not addressed here. Brown and Santoni (1982) discuss the possible impact of the Accord of 1953 and price controls.

192 ECONOMIC INQUIRY

TABLE 1

36

Ai = 01 + c @ , A M , , j = O

1951-79 1951-65 Coefficient ( t stat) EP, in basispts. Coefficient ( t stat) ED, in basis pts.

a P o P I

02 P 3

P 4

P S

0 6

0 7

P 8

P, P 1" P I ,

P I 2

P 13

P 14

P 1s

P 16

P 17

P 18

P 19

P, 0 2 1

022

P, P24

07.5 P 26

P 27

P, 029 P m

P 3 ,

P 32

P, 634

P, 0 36

,0002 ( 1.31) -.0376 (-6.13) -.0232 (-3.24) -.0126 (-1.66) .0005 ( .07) .0028 ( .36) .0033 ( .41) .0192 ( 2.33) .0218 ( 2.59) .0083 ( .96)

-.0039 ( -.45) .0067 ( .78) .0055 ( .63)

-.0033 ( -.37)

.0087 ,0074 .0055 .0150 .0116 .0162 .0268 ,0259 .0194 .0068 .0149 .0068 ,0036 .0068 .0130 .0192

.99)

.82)

.60) 1.64) 1.27) 1.76) 2.92) 2.82) 2.11)

* 75) 1.67) .78) .42)

1.48) 2.40)

.79)

.0210 ( 2.44)

.0279 ( 3.30)

.0267 ( 3.19)

.0152 ( 1.84)

.0079 ( .97)

.0150 ( 1.32)

.0041 ( .55)

.0072 ( 1.13)

-3.76 -6.08 -7.34 -7.29 -7.01 -6.68

-2.58 -1.75 -2.08 -2.47 -1.80 -1.25 - .38

.36

.91 2.41 3.57 5.19 7.87

10.46 12.40 13.08 14.57 15.25 15.61 16.29 17.59 19.51 21.61 24.40 27.07 28.59 29.38 30.43 30.84 31.56

-4.76

O1

P o

P I

P 2

P , P , P S

P, P ; P, P , P 10

01,

P I P

P 13 P 14

P 15

P 16

P 17

P 18 P 19

P 20

P 2 l

P 22

P 23

P 24

P, P 26

P 2, P 29

P3c

0 3 1

P 32

P, Pa

P 35

P 2 7

36

-

.0001 ( .93) -.0252 (-5.45) -.0252 (-4.36) -.0207 (-3.42) -.0169 (-2.75)

.0007 ( .11) ,0150 ( 2.32) .0208 ( 3.13) .0209 ( 3.11) ,0126 ( 1.87) .0111 ( 1.64) .0150 ( 2.23) ,0071 ( 1.07) .0045 ( .68) .0111 ( 1.69) .0112 ( 1.72) .0180 ( 2.76) .0173 ( 2.64) .0137 ( 2.06) .0225 ( 3.41) .0211 ( 3.20) .0190 ( 2.91) .0149 ( 2.28) .0170 ( 2.60) .0028 ( .43)

-.0025 ( -.37) .0007 ( .lo) .0014 ( .21)

.0047 ( .73)

.0098 ( 1.52)

.0095 ( 1.50)

.0123 ( 1.99) ,0085 ( 1.38)

-.0062 (-1.06) .0003 ( .06)

-.0094 (-1.51)

-.0018 ( -.27)

-.0012 ( -.20)

-2.52 -5.04 -7.11 -8.80 -9.74 -9.67 -8.17 -6.09 -4.00 -2.74 -1.63 - .13 - .58

1.03 2.14 3.26 5.06 6.79 8.16

10.41 12.52 14.42 15.91 17.61 17.89 17.64 17.71 17.85 17.67 18.14 19.12 20.07 21.30 22.15 22.03 21.41 21.44

- R 2 = .13 R 2 = .27

MELVIN: THE VANISEIINC: LIQUIDITY E F F E C T 193

TABLE 1 (continued)

36

A i = a + c P , A M , , j = O

1966-79 1973-79 Coefficient ( t stat) C P , in basispts. Coefficient ( t stat) C P , in basis pts.

CY

P 0

PI 6 2

P 3

P4

05 P, P 7

P, PL!

P 10

P I ,

P 12

P 13 P 14

P 15

P 16

P 17

P 18

P 18

P 2"

0 2 1

P 22

P, 024

P 25

P 26

6 2 7

Pa

P 29

P m

P 31 P 32

P 33

034

0% P 36

-

.0004 ( 1.11) -.0465 (-3.97) -.0168 (-1.29) -.0076 ( -.54)

.0135 ( .95)

.0121 ( .83)

.0093 ( .63)

.0244 ( 1.61)

.0256 ( 1.64)

.0015 ( . lo) -.0079 ( -.49) -.0106 ( -.66)

.0009 ( .06)

.0015 ( .09)

.0104 ( .63)

.0046 ( .27)

.0057 ( .32)

.0214 ( 1.20)

.0136 ( .77)

.0253 ( 1.43)

.0329 ( 1.86) ,0338 ( 1.74) .0221 ( 1.26) .0022 ( .13) .0153 ( .92) .0074 ( .46)

.0116 ( .73)

.0245 ( 1.50)

.0344 ( 2.09)

.0340 ( 2.08)

.0428 ( 2.68)

.0439 ( 2.77)

.0276 ( 1.76)

.0128 ( .83)

.0214 ( 1.40)

.0074 ( .53)

.0052 ( .41)

.0120 ( .77)

R 2 = .08

-4.65 -6.33 -7.09 -5.74 -4.53 -3.60 -1.61

1.40 1.55

.76 -.30 -.21 -.06

.98 1.44 2.01 4.15 5.51 8.04

11.33 14.41 16.62 16.84 18.37 19.11 20.31 21.47 23.92 27.36 30.76 35.04 39.43 42.19 43.47 45.61 46.35 46.87

a P 0

PI 0 2

P , P , P S

P , P i P , P :, P 1" 011

PI? P I, P 11

P 1s P 16

P 1; P 18

P 19

P 20

021

P 22

P 23

P 21

P 25

P 26

P 27

P 2R

P 2!1 A" P 3 ,

P 12

P 33

0% P 35

P 36

R 2 -

.0007 ( 1.15)

,0415 ( 1.63) ,0694 ( 2.44) .0908 ( 3.03) ,0755 ( 2.33) .0754 ( 2.22) .0925 ( 2.55) .0855 ( 2.18) .0334 ( .84)

-.0178 ( .43) -.0430 (-1.03) -.0364 ( -.86) -.0385 ( .91) -.0515 (-1.21) -.0560 (-1.31) -.0560 (-1.30) -.0140 ( -.33)

.0318 ( .74)

.0442 ( 1.04) ,0488 ( 1.15) .0393 ( .94)

.0268 ( .66)

.0335 ( .86)

.0365 ( .95)

.0664 ( 1.70)

.0980 ( 2.54)

.1151 ( 2.96)

.lo91 ( 2.81)

.1346 ( 3.83) ,1380 ( 4.04) .1244 ( 3.72) .0873 ( 2.79) .0679 ( 2.48) .0232 ( .92) .0143 ( .67)

-.0259 (-1.21)

-.0009 ( -.02)

.0089 ( .21)

= .22

-2.59 1.56 8.50

17.58 25.13 32.67 41.92 50.47 53.81 52.03 47.73 44.09 40.24 35.09 29.49 23.89 22.49 22.40 25.58 30.00 34.88 38.81 39.70 42.38 45.73 49.38 56.02 65.82 77.32 88.23

101.69 115.49 127.93 136.66 143.45 145.77 147.20

194 ECONOMIC INQUIRY

TABLE 2

12

Ai = a + c @ , A M , - , i = O

1951-79 Coefficient (t stat) C P , in basis pts.

1951-65 Coefficient ( t stat) C P , in basis pts.

a .0003

P I -.0247

0, -.0032 P, -.0033

P o -.0382

0 2 -.0137

0 5 -.0066 f l 6 a0085 p i .0096 0, -.0012 P g -.0115 PI, -.0100 f i l l -.0003 P,, -.0027 - RZ = .12

( 1.90) (-6.53) (-3,68) (-1.94) ( -.46) ( -.47) ( -.91) ( 1.18) ( 1.32)

(-1.57) (-1.38) ( -.05)

( -.17)

( -.44)

-3.82 -6.29 -7.66 -7.98 -8.31

-8.12

-7.28 -8.43 -9.43 -9.46 -9.73

-8.97

-7.16

a .0002 Po -.0228 P I -.0255 0 2 -.0208 (3? -.0152 p, -.0100 p 5 -.0047 P, .008 1 0 7 .0118 08 .0118 P q .003 1 (3," .0056 PI, .0097 PI, .0029 - R 2 = .18

( 1.68) (-5.13) (-4-67) (-3.62) (-2.62) (-1.71) ( -.80) ( 1.37) ( 1.99) ( 2.01) ( -53) ( ,97)

( .65) ( 1.76)

-2.28 -4.83 -6.91 -8.43 -9.43 -9.90 -9.09 -7.91 -6.73 -6.42 -5.86 -4.89 -4.60

12

A i = a + c P , A M , - , j = O

1966-79 Coefficient ( t stat) C P , inbasispts.

1973-79 Coefficient ( t stat) C P , in basis pts.

,0005 - ,0506 -.0220 -.0129

.0027 -.0011 - .0074

.0072

.0085 - .0099 -.OM5 -.0170 -.0057 - .0067

( 1.37) (-4.80) (-1.92) (-1.07) ( .22) ( .09)

( *58) ( .68) ( 779)

( -.60)

(-1.45) (- 1.34) ( -.48) ( -.59)

-5.06 -7.26 -8.55 -8.28 -8.39 -9.13 -8.41 -7.56 -8.55

-10.40 -12.10 -12.67 -13.34

a .0008 Po -.0510 PI .0101 PI .0313 0, .0440 P , .0274 P S .0260 PI3 .0537 Pi .0554 P 8 .0330 P Q -.0048

P I , .0063 P12 .0145

R 2 = .15

-.0086

-

( 1.36) (-2.65)

( 1.24) ( 1.69)

( *44)

( 1.00) ( .go)

( 1.11)

( .24) ( *66)

( 1.81) ( 1.82)

( -.16) ( -.30)

-5.10 -4.09 -.96 3.44 6.18 8.78

14.15 19.69 22.99 22.51 21.65 22.28 23.73

- R 2 = . l l

MELVIN: THE VANISIIING LIQUIDITY EFFECT 1!15

of why the differences arise. Stokes and Neuberger examined cross correlations between money and lagged interest rates concluding that “the feedback of interest rates on the nominal money stock, which indicates that a rise in the interest rate will slow the rate of change of the nominal money stock several periods later, cannot be rejected by diagnostic tests” (p. 541). Such feedback effects are not of the sign gener- ally expected considering the literature on the lag in effect of monetary policy. Tra- ditionally, we expect the feedback from interest rates to money to reinforce the infla- tionary consequences of an increase in money growth. Over twenty years ago Friedman (1961) explained that feedback effects following an increase in money growth would result in the process of adjustment to a new money growth rate being drawn out over time. If we focus specifically on the feedback effects of interest rates via money demand, then we traditionally expect to see a positive relation between interest rates and money growth. Darby (1979), in a brief summary of this litera- ture, states “the interest elasticity of money demand reinforces the inflationary effects of a stimulative monetary policy with an upward shift in the price level” (p. 213). The conventional story is that after interest rates begin to rise following an increased money growth rate, the higher interest rates will lower money demand which will bring about a further increase in expected inflation and hence interest rates; so that we would expect the sort of continuing rise in the interest rate depicted in figure 2 by the three lower lines.

Stokes and Neuburger suggest that the interest rate pattern displayed for the more recent period perhaps “reflects a switch out of M , and into other monetary assets” (p. 541). However, they are apparently trying to reconcile the observed drop in rates after about a year with the traditional lag relationship stories emphasizing the demand side effects of higher interest rates.5 The key to this puzzle may instead lie on the supply side. As the effects of inflationary expectations on interest rates have become better understood, opinions regarding the appropriate conduct of monetary policy have been revised. As will be emphasized in the next section, it appears that in the mid- to late 19605, the U.S. economy experienced a substantial change in the way inflationary expectations were reflected in interest rates. Over time, it is reasonable to expect policymakers to formulate monetary policy in the context of this new structure. Specifically, in the early sample period it was com- monly believed that an expansionary monetary policy would significantly lower interest rates, while in the more recent period policymakers realized that during a time of high interest rates caused by rapid inflation (as experienced over much of the 1973-79 period) increasing money growth would only add fuel to the fire of antici- pated inflation and thus increase nominal interest rates further. For this reason, it is likely that the particular difference in the time pattern of interest rates between the early and recent samples at about a year’s lag is due to the fact that the early period saw increases in money growth aimed at lowering interest rates, while the recent inflationary period saw the policymaker’s response to rising interest rates being lower money growth rates whenever money growth specifically was aimed at inter- est rates. Rather than the substitutions out of M , mentioned by Stokes and

5 . An alternative money demand story could describe the observed pattern in figure 2. The decrease in money demand following the higher interest rates could cause short-term rates to fall to equilibrate the money market if prices do not adjust immediately to the lower money demand. This decrease in short- term rates could conceivably occur even though long-term rates are rising in anticipation of higher future inflation rates. Mishkin (1981) provides empirical evidence that long-term rates show no significant nega- tive correlation with increases in the money supply.

196 ECONOMIC INQUIRY

24 - 22 - 20 - 18- 16- 14- 12-

Neuburger, the change in monetary policy stands as an alternative explanation. A brief review of actual policymaking will address this issue below (section IV and footnote 11).

An examination of the 12 month lag patterns exhibited in figure 3 indicates that once again the results are sensitive to sample period choice. The three lower lines for 1951-79, 1951-65 and 1966-79 all yield insignificantly different results and suggest that interest rates fall for around five months before an upturn occurs. However, the 1973-79 period does yield significantly different results as an F test for equality of coefficients over the 1951-72 and 1973-79 periods yields a computed F of 3.45 while F.05,,1,320 is approximately 1.7. The more recent period indicates once again that the liquidity effect is of shorter duration than previously thought.

FIGURE 3

The Effect of Changes in Money Growth on Interest Rates 12 month unconstrained lags

1973 to 1979

I

i

-1 2 'sad 1966 to 1979 I I I 8 I I I

0 2 4 6 8 1 0 1 2

Months

Some qualifying remarks regarding the estimates presented here are in order. Certainly this is not a complete model of interest rates. Important determinants of the rate of interest are omitted. While the author [Melvin (1982)l has a structural model of interest rate determination that is being used in other work, the questions at hand do not call for such a model. In fact, it would be unfair to the earlier authors

MELVIN: THE VANISHIKG LIQUIDITY EFFECT 197

cited above to change the methodology.6 All things considered, it would seem quite reasonable to use, as the previous authors have, long distributed lag regressions to find the answers. What is interesting in the present study is the dissimilarity between the new results and the earlier findings.

I l l . INFLATION A N D THE LIQUIDITY EFFECT

If we accept the inference presented above, that the liquidity effect of money on interest rates has become much shorter lived in recent years, then the interesting question is why. As was pointed out in section I , after the initial drop in interest rates caused by an increased rate of growth of money, rates would tend to increase due to the financial, income, and expectations effects. Regarding the financial effect, it is not clear that banks have been able to adjust to their loan portfolios more quickly in the 1970’s than in earlier times. If a quicker adjustment has, in fact, occurred, then we would expect a more rapid increase in interest rates following the initial fall in rates.

Considering the income effect, if changes in nominal income have more closely followed changes in money growth over the more recent past, then the income effect should contribute to the faster rise in rates following an increase in the growth rate of the money supply. There is some evidence suggesting that this has not been the case. Tanner (1979) investigated the variability of the lags in the effects of money on income concluding that “the lags in the effects of monetary policy were substantially longer in 1974 than they were twenty years earlier” (p. 114). It seems highly unlikely then that the dramatic shortening of the observed liquidity effect could be due to a changing income effect.

If the financial and income effects can be ruled out as an explanation of the change in monetary effects on interest rates, then the focus falls on the Fisher or expectations effect. A number of studies in recent years have found evidence of a structural change in the magnitude of the coefficient on expected inflation in a Fisher equation (see Cargill and Meyer (1974, 1977) and Holmes and Kwast (1979), for instance). Holmes and Kwast suggest that such structural change is due to “an increased awareness of price level changes by market participants, increased flexi- bility of interest rates, and an increase in the ratio of the benefits of predicting inflation to the costs of doing so” (p. 735). Evidence of this “increased awareness” is provided by the increasing attention given to the money supply data published by

6. In a very instructive article, Stokes and Neuburger have suggested that long distributed lag regres- sions of the type used by Gibson, Cagan, and Cagan and Gandolfi are “usually hampered by multi- collinearity except in the unlikely case where the independent variable happens to be prewhitened at the outset” (p. 535). Yet Cagan and Gandolfi explicitly mention the low autocorrelations of the change in money growth rates they use as “one advantage of running the regression in first-difference form” (p. 281). It is, in fact, comforting to note that the time pattern of response found by Stokes and Neuburger’s transfer functions resemble the new evidence reported here.

There are a few additional comments one might make regarding the methodology followed by Stokes and Neuburger. They argued that they could estimate the liquidity and income effects separately by using one filter cross correlations between the percentage change in money and the percentage change in inter- est rates for the liquidity effect, and the change in money with the level of the interest rate for the income effect. Besides the questionable distinction drawn between the functional forms appropriate for deter- mining the income and liquidity effects, we must also be aware that the financial effect will muddle matters considerably regarding the identification of any income effect. These comments are not meant to disparage the contribution of Stokes and Neuburger. Their study, in particular their transfer function estimates and their discussion of the merit of alternative econometric approaches, is a valuable contribution.

198 ECONOMIC INQUIRY

the Federal Reserve. As the new data comes out each period, the market reacts (some would argue “over-reacts”) . The market certainly did not ignore monetary policy prior to the 1970’s. Still there may have been a learning process that has led to an increased role for the money supply data in recent yearsS8 One can point to the changing U.S. monetary standard as underlying this learning process. Based on his empirical results, Benjamin Klein (1975) concludes:

Evidence suggests that only over the last decade has the public generally recog- nized the fundamental change from a commodity to a fiduciary standard that has occurred in the underlying monetary framework (p. 461).

In this sense, no expectations effect of any consequence should appear until the 1960’s.

The evidence presented here suggests that U.S. financial markets have adapted to the changing monetary standard and inflationary experience in a way quite similar to the interest rate response in Latin American countries that long have experienced inflation. Friedman (1968) suggested that the process of adjustment following a monetary policy change is “greatly speeded up” for countries that have experienced rapid inflation, like the Latin American countries. Friedman’s claim has received empirical support from studies such as Holden and Peel (1979), Vogel (1974), and Blejer (1978).

Based on an investigation of the relation between money and interest rates in Argentina, Blejer found that the expectations effect was dominant even within the quarter in which monetary change takes place. He concludes that his results differ from those found in Cagan and Gibson for the U.S. due to:

the consequence of greater sensitivity to inflation on the part of economic agents when the average inflation rate is higher. The fast increase in nominal interest following a monetary expansion seems to indicate that in countries with a long history of rapid inflation economic agents tend to invest more resources in improving their inflation-forecasting technology, thereby hastening the process of translating monetary changes into price expectations (p. 533).

In light of the new evidence presented here, as well as that cited above, it would appear that the U.S. of the 1970’s is not much different, in regard to the effects of money on interest, than Argentina or other countries with a long history of inflation.

While the new evidence presented so far has indicated the significant change in the relationship between money and interest rates, the work cited in support of the explanation for this change is only suggestive. If in fact the shortening liquidity effect is due to a “greater sensitivity to inflation on the part of economic agents when the average inflation rate is higher” as Blejer has stated, then we should be able to

7. For an analysis of the short-run response of interest rates to the weekly money supply announce-

8. In an analysis of rational expectations with costly information, Darby (1976) derives the result that: ments, see Grossman (1981).

. . . an exogenous variable will be used in formulating expectations only if it has significant variance which is not explained by other more readily usable variables including past values of the predicted variable. This provides a theoretical basis for changes in methods of expec- tations formation between a period of stable monetary growth and periods of large variance in monetary growth . . . or stable economies against hyperinflations (p. 893).

MELVIN: THE VANISHING LIQUIDITY EFFECT 199

test the hypothesis that inflation affects the responsiveness of market interest rates to changes in money growth. Reformulating the distributed lag equation in terms of a varying parameter problem allows a test of this hypothe~is.~

Suppose the p coefficients in equation (1) are not fixed but instead vary with the rate of inflation such that:

Then as the rate of inflation varies we expect also to vary. In equation (2), the y, now refer to the “fixed” distributed lag relationship between money and interest while the variable effect will be captured by 6, Pt., . Estimating the varying parame- ter version of our distributed lag model obviously involves multiplicative terms between lagged money growth and inflation rates.

Defining k as the rate of inflation (as measured by the C.P.I.) over the past twelve months, the variable distributed lag approach may be estimated over the 1951-79 period as reported in table 3.1° As mentioned above, the y’s are the estimated fixed weights while the contribution of the variable weights, the 6 P terms, are eyaluated at the sample mean of P. To derive the aggregate weights we sum + 8 P as shown in the third column of table 3.

TABLE 3

Variable Weight Distributed Lag of the Effects of Money Growth on Interest Rates, 1951-79

i +, (t stat) 8, (t stat) f, + s*, P C (+, + 8, P, ,) in basis pts

0 -.0188 1 -.0428 2 -.0469 3 -.0399 4 -.0328 5 -.0316 6 -.0246 7 -.0102 8 .0025 9 -.0012

10 .0060 11 .0150 12 .0060

(-1.93) (-3.61) (-3.74) (-3.16) (-2.57) (-2.46) (-1.89) ( -.79) ( .19) ( -.09) ( .45) ( 1.21) ( *GO)

aZ = ,0003 (1.71)

-.3952 (-2.12) ,4821 ( 2.12) .7709 ( 3.19) .8214 ( 3.35) .6597 ( 2.65) .5263 ( 2.04) .7363 ( 2.75) .5178 ( 1.92)

-.0128 ( -.05) -.1837 ( -.67) -.3206 (-1.14) -.3802 (-1.44) -.1519 ( -.70)

-.0338 - .0245 -.0176 -.0087 -.0077 -.0116

,0034 .0095 .002 .0082

-.0062 .0006 .0002 - R 2 = .20

-3.38 -5.83 -7.59 -8.46 -9.23

-10.39 -10.05 -9.10 -9.10 -9.09 -9.10 -9.10 -9.10

9. Tinsley (1967) provides an early example of variable weight distributed lags. For a recent applica-

10. Given the increase in the number of parameters to be estimated with the varying parameter tion in a macroeconomic setting see Tanner (1979).

approach, the focus is on the 12 month lags.

200 ECONOMIC INQUIRY

As expected, the cumulative sum of the aggregate weights over time suggests a pattern quite similar to that given in table 2 for the 1959-79 period. By themselves, the fixed weights (y’s) of table 3 would suggest a more pronounced and sustained liquidity effect, but the positive effect of the variable weights for the first through the seventh lag illustrates the effect that inflation has had in moderating the liquid- ity effect (where the aggregate weights will increase with inflation, bringing about a quicker upturn in interest rates).

The hypothesis that the relationship between money and interest is unaffected by inflation is equivalent to the hypothesis that the variable weight terms involving 6 are jointly zero. An F test for the joint significance of the 6 terms yields a calculated F of 3.71, while F.0i,,1,32, is approximately 2.18. Thus we do indeed find that the relationship between money and interest depends, in a systematic way, upon the inflationary environment.

IV. POLICY IMPLICATIONS

Earlier research has indicated that the Federal Reserve could induce falling inter- est rates for two or three quarters by increasing the growth of the money supply. This is a sufficiently long horizon to be politically attractive, and for much of the time period studied, the Federal Reserve System followed a policy of actively managing interest rates. The new evidence indicates that the lowering of interest rates follow- ing a higher growth rate of money is so short-lived as to be hardly worth the increased inflation purchased by the higher money growth rate. By the early 1970’s official pronouncements indicated an awareness of the worsening trade-off availa- ble to the policymaker. In 1973, Arthur Burns stated:

At present there is no real alternative to a restrictive monetary policy. To be sure, if we permitted money and credit to expand at a more rapid pace, short-term interest rates would decline for a brief period. But in so doing we would be adding fuel to the inflationary fires now raging. Before very long interest rates would rise again, and probably well beyond their present level, as both lenders and borrowers adjusted to the quickened pace of inflation. The simple and ines- capable truth is that inflation and high nominal interest rates go together (p. 656).

Thus the Chairman of the Federal Reserve System was aware that the liquidity effect was so short as not to be worth the inflationary consequences of higher money growth, and in fact the growth of the money supply was slowed through 1973.11 Of course official pronouncement and actual policy have not always coincided, and often there has been official disagreement regarding the appropriate monetary pol- icy both among the governors of the Federal Reserve System as well as between Congress and the Federal Reserve System. In March, 1975, the view of Congress was communicated through a resolution (House Concurrent Resolution 133) asking that

11. One may note that the quote lends support to the argument offered in section I1 as to the likely explanation for the differences in the time pattern of interest rates after about a year between the early and late period results shown in figure 2. In the early period it was commonly believed that when interest rates were rising, the appropriate policy was to increase money growth, but in the inflationary 1973-79 period, the appropriate response to the inflation-induced high interest rates was a decrease in money growth, or at least not an increase.

MELVIN: THE VANISHING LIQUIDITY EFFECT 20 1

the Federal Reserve System:

. . . encourage lower longer term interest rates and expansion in the monetary and credit aggregates . . .

Thus Congress still viewed as favorable the trade-off between reducing interest rates now and suffering higher inflation later, and requested that the Federal Reserve System increase money growth with the specific goal of reducing interest rates.

In more recent times, U.S. monetary policy increasingly has emphasized money growth targets and deemphasized controlling interest rates but this policy has had its share of critics. During periods of high interest rates, politicians and economists alike have called for the Federal Reserve System to increase money growth in order to reduce interest rates. The new evidence presented here indicates the very small ben- efit to be derived from a monetary expansion aimed at lowering interest rates.

V. CONCLUSIONS

Following an increase in the growth rate of the money supply, we observe interest rates falling at first and then rising; this empirical regularity holds for both the old literature as well as the new estimates presented here. The older results of Cagan, Cagan and Gandolfi, and Gibson had suggested that the initial drop in rates would last four to nine months before rising interest rates would be observed. The new results presented in this paper indicate that the pattern of response has changed considerably over the recent past. The initial liquidity effect of the faster money growth is likely to be offset within the month following the monetary policy change.

In section I it was pointed out that after the initial drop in interest rates caused by an increased rate of growth of money, rates would tend to increase due to the finan- cial, income, and expectations effects. Regarding the financial effect, it may well be that banks adjusted their loan portfolios more quickly over the 1970’s than in earlier times, thus leading to a more rapid increase in interest rates following the initial fall in rates. There is evidence, however, suggesting that the income effect cannot explain the change in the monetary effects on interest rates as the lag between money and income seems to have lengthened over time. The existing literature, along with the new evidence presented here, indicates that inflationary expectations deserve most of the credit for the change in the time pattern of monetary effects on interest rates. Through the 1970’s increasing attention has been given to the money supply data published by the Federal Reserve. Considering the public’s perception of our changing monetary standard, it is not surprising that a change in structure has been observed regarding the impact of inflationary expectations on interest rates. In fact, it appears as though the U.S. of the recent past is not much different in regard to the monetary effects on interest rates than Argentina or other countries with a long history of inflation.

In terms of policy implications, the earlier research indicated that the Federal Reserve could induce falling interest rates for two or three quarters by increasing the growth of the money supply. The new results indicate that the lowering of interest rates is so short-lived that the short-run political, as well as economic, benefits from a monetary expansion aimed at lowering interest rates tend to be negligible. Consid- ering the increased inflation purchased with the higher money growth rate, the evidence presented here should give pause to those who argue to lower interest rates by increasing money growth.

202 ECONOMIC INQUIRY

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