Rethinking the Liquidity Puzzle: Application of a New Measure of the Economic Money Stock

Abstract

Historically, attempts to solve the liquidity puzzle have focused on narrowly defined monetary aggregates, such as non-borrowed reserves, the monetary base, or M1. Many of these efforts have failed to find a short-term negative correlation between interest rates and monetary policy innovations. More recent research uses sophisticated macroeconomic and econometric modeling. However, little research has investigated the role measurement error plays in the liquidity puzzle, since in nearly every case, work investigating the liquidity puzzle has used one of the official monetary aggregates, which have been shown to exhibit significant measurement error. This paper examines the role that measurement error plays in the liquidity puzzle by (i) providing a theoretical framework explaining how the official simple-sum methodology can lead to a liquidity puzzle, and (ii) testing for the liquidity effect by estimating an unrestricted VAR