Searching for the Liquidity Effect in Canada

Ben Fung and Rohit Gupta
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Rohit Gupta: Bank of Canada

Staff Working Papers from Bank of Canada

Abstract: 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. Les auteurs examinent empiriquement la pertinence des effets de liquidite au Canada. Sous l'hypothese d'effet de liquidite, l'incidence initiale d'un choc expansionniste non anticipe de la politique monetaire consiste en une diminution momentanee des taux d'interet nominaux et reels. Cependant, comme les anticipations d'inflation s'ajustent au nouveau taux d'expansion monetaire, leur effet finit par se manifester et dominer l'effet de liquidite. Les taux d'interet se mettent alors a augmenter. Dans leur etude, les auteurs font appel a la methode d'estimation des vecteurs autoregressifs pour etudier comment les taux d'interet, la production et les taux de change reagissent aux chocs de politique monetaire. Ils se servent des reserves excedentaires des banques a charte et de leur composante non anticipee comme mesures des chocs de la politique monetaire. Plus precisement, ceux-ci sont mesures par les innovations orthogonalisees de ces variables de liquidite. Les auteurs ont observe que les chocs expansionnistes de politique monetaire sont suivis par des baisses de taux d'interet, des hausses de la production et des depreciations du dollar canadien. Les resultats obtenus resistent bien aux changements d'agencement des variables utilisees dans l'estimation des vecteurs autoregressifs. La reaction des taux d'interet aux chocs de politique monetaire est peu sensible aux diverses mesures de liquidite utilisees, mais la reaction des autres variables a tendance a varier legerement.

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