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A Theoretical and Empirical Examination of the Liquidity Effect

Keen, Benjamin David
Thesis/Dissertation; Online
Keen, Benjamin David
Otrok, Chris
Recent theoretical and empirical macroeconomic studies encounter difficulties in explaining key features of the monetary transmission process. Most of the theoretical models lack mechanisms to account for the empirically observed liquidity effect and the large positive real effects following a monetary policy shock. On the other hand, empirical studies rely on identifying assumptions, as opposed to a structural model, to produce the effects of a monetary disturbance. This dissertation develops and estimates a dynamic stochastic general equilibrium (DSGE) model that captures many of the observed qualitative and quantitative properties of a monetary policy shock. Chapter 1 examines the impact of a monetary policy shock in a DSGE model with sticky prices and financial market frictions. First, we examine the shortcomings of monetary models emphasizing these frictions individually. The model then is specified to limit the response of prices and savings to a cu rrent period monetary disturbance. Our results show that this model can account for the following key responses to an expansionary monetary policy shock: a fall in the nominal interest rate; a rise in output, consumption, and investment; and a gradual increase in the price level. Finally, a detailed sensitivity analysis shows the model's results depend on the parameters assigned to critical structural features. Chapter 2 develops a DSGE model with sticky prices and financial market frictions and estimates its parameters by maximum likelihood using U.S. data on output, inflation, interest rates, real money balances, and investment. The empirical plausibility of this estimated business cycle model is evaluated by comparing its qualitative and quantitative results with those found in the data. Results show this model mimics many important features of the business cycle. In particular, our model generates reasonable impulse responses and only a modest amount of the variation in output and inflation is due to monetary policy shocks. This model also generates a key feature often missed by other models: a rise in the current nominal interest rate predicts a fall in output four to six quarters into the future.
University of Virginia, Department of Economics, PhD, 2002
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