The Liquidity, Income, and Fisher Effects of Money on Interest

Abstract

This paper examines empirically the dynamic effect of money supply on interest rates. Since previous studies have a misspecification problem and overestimate the Fisher effect from the increase in money supply on interest, they do not find the dynamic response of money on interest rate. In order to provide the plausible dynamic relationship between money supply and interest rate and investigate how long the liquidity effect exists. this paper applies vector autoregressive (VAR) model and impulse response function. Based on these econometric methods this paper reports new evidence on this issue. That is, the liquidity effect does not vanish fast, rather it appears to be significant during the first 5-7 quarters. The accumulative effect of money supply on interest rate is that the liquidity effect would be dominant over the income effect and the Fisher effect.