This paper examines the empirical evidence of the liquidity effect in Canada. In the presence of the liquidity effect, the initial impact of an unanticipated expansionary monetary policy is to lower nominal and real interest rates for a short period of time. Eventually, however, the anticipated inflation effect will come into force and dominate the liquidity effect as people adjust their inflation expectations to the new money growth rate. As a result, interest rates will then increase. In this paper, we use vector autoregression (VAR) methods to study how interest rates, output and exchange rates respond to shocks to monetary policy. We use the excess cash reserves of the chartered banks and the surprise component of excess cash reserves as measures of monetary policy shocks. Shocks to monetary policy are measured by the orthogonalized innovations to these liquidity variables. We find that expansionary shocks to monetary policy are followed by declines in the interest rate, increases in output, and depreciations of the Canadian dollar. The results are robust to different orderings of the variables used in the VAR estimation. The response of the interest rate to monetary policy shocks is robust to different measures of liquidity, but the responses of other variables vary slightly.

Also published as:

Canadian Journal of Economics (0008-4085)
November 1997. Vol. 30, No. 4b, pp. 1057-82