Interpreting Money-Supply and Interest-Rate Shocks as Monetary-Policy Shocks

In this paper two shocks are analysed using Canadian data: a money-supply shock ("M-shock") and an interest-rate shock ("R-shock"). Money-supply shocks are derived using long-run restrictions based on long-run propositions of monetary theory. Thus, an M-shock is represented by an orthogonalized innovation in the trend shared by money and prices. An R-shock is represented by the orthogonalized innovation in the overnight interest rate. Either type of shock might be interpreted as a monetary-policy shock. A permanent increase in the nominal stock of M1 generates: a temporary fall in the interest rate, consistent with the liquidity effect; a temporary rise in real output; a permanent increase in the price level; and a permanent depreciation of the nominal exchange rate. Although the behaviour of M1 is not directly controlled by the central bank, the identifying assumption that the central bank controls the long-run trend in money and prices and has no long-run effect on real output appears to be quite reasonable. A temporary positive real-interest-rate shock generates a temporary fall in money and output, but prices rise initially (a "price puzzle") before eventually declining. Both the M-shock and R-shock models are consistent with an active role for money in the transmission of monetary policy