Retrieving the vanishing liquidity effect—a threshold vector autoregressive model

Abstract

This paper employs a threshold vector autoregressive (TVAR) model where the data is subdivided into low and high inflation regimes. Monetary policy is endogenized in this framework and two different measures of monetary policy, viz. NBR and M1, are investigated. The interest rate is hypothesized to respond inversely to increased monetary growth in the low inflation regime and positively to increased monetary growth in the high inflation regime. In the low inflation regime, expansionary monetary policy shocks are found to depress the interest rate over 10 and 5 periods for nonborrowed reserves and M1 growth, respectively. Whereas, in the high inflation regime, both measures generate positive responses. It follows that the hypothesized threshold behavior between money and the interest rate is supported regardless of monetary measures.