The Liquidity Effect in the Federal Funds Market: Evidence at the Monthly Frequency


  • The views expressed are those of the authors and do not necessarily reflect those of the Board of Governors or the Federal Reserve System. We thank Oscar Jorda and an anonymous referee for helpful comments, and Marcus Cuda. Shawn Liu and Brianna Wilcox provided excellent research assistance. Any errors, however, are solely those of the authors.


In this paper, we argue that much of the research into the link between money and interest rates suffers from misspecification. The measure of money and the measure of interest rates are not always well matched. In examining the transmission of monetary policy, we show that using an appropriate measure of money, Federal Reserve balances, and the appropriate interest rate, the federal funds rate, a clear liquidity effect exists. Furthermore, we explain how a lack of a clear institutional understanding may have contributed to the finding of a “liquidity puzzle” in the past.