Monetary Policy and Economic Activity in Japan, Korea, and the United States

A cornerstone of central bank policy is that a looser monetary policy is associated with lower interest rates, higher growth of narrow monetary aggregates, higher output and higher inflation. These responses, which we collectively refer to as the liquidity effect hypothesis, are commonly maintained in practice but are at odds with some leading models of money. This paper proposes and implements a methodology for assessing the liquidity effect hypothesis with two other hypotheses: The costly price adjustment hypothesis and the inflation tax hypothesis. We find surprisingly little support for the liquidity effect hypothesis in Japanese or U.S. data. The liquidity effect hypothesis receives its strongest support in Korean data.