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Why the Liquidity Effect May Not Predict Interest Rate Changes

Article Quant Q&A · Author: Mohamed Amr
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Summary

The question asks how interest rates respond when the money supply falls and the liquidity effect outweighs other effects, assuming the economy adjusts slowly. The response cautions that this setup is underspecified and that the direction of the interest rate response is not fixed by the liquidity effect alone.

It points to results from a New Keynesian model, where outcomes can vary with the model’s calibration. The document therefore gives a warning about drawing a simple directional conclusion from a money supply shock without specifying model structure and parameter values. It cites figures from prior research but does not reproduce them or provide enough detail to establish a particular predicted path.

Key ideas

  • The interest rate response to a money supply shock can depend on the model’s calibration.
  • The liquidity effect alone does not determine the direction of the interest rate response.
  • A clear answer requires more context about the economic model and assumptions.
  • The cited discussion refers to model figures but does not include their details.

Tags

Fixed incomeStatistics
Full text
# Liquidity effect in case MS decrease


# Liquidity effect in case MS decrease












What is the result if the liquidity effect is grater than other effects in case of decreased money supply?

I got this question on the exam, In case of an increase in the money supply by the central bank what will happen if the liquidity effect is greater than the other effect (price level inflation... Effects) and the economy adjust slowly The answer would be that the interest rate will fall and rise slowly

The next question was what if the liquidity effect is greater than other effect and the economy adjust slowly in can of decreased money supply?

## Answer by phdstudent (score 1)

https://quant.stackexchange.com/a/22026

Your question is quite confusing, and obviously not straighforward if you don't give more context. In fact, considering the simpler New Keynesian model several answers are possible depending on calibration.

The liquidity effect impact to an exogenous money supply shock can have several directions. Check the figures below from Gali (2001):

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.