Asymmetric Effects of Money Supply Shocks and Trend Inflation

Abstract

IN RECENT YEARS, a number of empirical studies have presented evidence that money supply shocks have asymmetric effects; that is, unexpected negative changes in the money supply slow the economy more than unexpected positive changes accelerate the economy. Evidence of asymmetry was documented by Cover (1992) for the postwar U.S. economy, and his finding was confirmed by De Long and Summers (1988), Morgan (1993), Rhee and Rich (1995), and Karras (1996a, b). Stimulated by these empirical works, several attempts have been made to provide microeconomic foundations for the asymmetric effects of money supply shocks.1 Among those theories, this paper examines the one that focuses on asymmetric price adjustment (and let us call it a sticky price theory). Money supply shocks will have asymmetric effects on real output if prices are less flexible downward than upward. This sticky price theory was proposed by Tsiddon (1993), Ball and Mankiw (1994), and Caballero and Engel (1992). By employing a menu-cost model, the above researchers show that positive trend inflation can produce the asymmetric effects of money supply shocks. The logic of their theory is the following: along with price adjustment costs, positive trend infla