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How do Interest Rate Changes by a Central Bank Affect the Economy?

This is an age old question in economics. In a recent paper by Mattias Almgren, José-Elías Gallegos, John Kramer and Ricardo Lima accepted for publication at the American Economic Journal: Macroeconomics, they find that monetary policy has a stronger effect in countries with a higher share of people who are "liquidity constrained".

Households who are liquidity constrained may have problems with unexpected expenses, because they do not have a sufficient money (liquidity) saved. This has implications for monetary policy makers because it implies that interest rate changes do not affect everyone equally. In particular, monetary policy may be contributing to the divergence of countries within a monetary union such as  the euro area.

As a first step towards the result, they estimate the responses of output to unexpected monetary policy shocks in the euro area, using a Local Projection Instrumental Variable approach combined with high-frequency identification. This setting is particularly useful for the posed question, because the countries share a central bank, and hence the same monetary policy. They find that output responses to the same shock are fairly different across countries within the Euro area.

Second, they estimate the share of individuals in each country who are liquidity constrained. Previous research has proposed a measure of individuals who live 'hand-to-mouth', i.e., consume all their income every month. They use two surveys, the Household Finance and Consumption Survey and the EU Survey on Income and Living Conditions, and 6 different variables. All measures give the same result: how much a country's output responds to monetary policy is highly correlated with the fraction of individuals who are liquidity constrained. This novel empirical finding confirms previous theoretical research.  

The findings support the notion that research on monetary policy needs to account for heterogeneity across the income and wealth distributions. Furthermore, they imply that liquidity is an important factor in how monetary policy shocks affect households and the real economy.

For more information, contact the researchers:

Mattias Almgren
José-Elías Gallegos
John Kramer
Ricardo Lima

Monetary Policy and Liquidity Constraints: Evidence from the Euro Area (preview)