The liquidity effect and the transmission mechanism of money

The positive relationship between money and interest rates and the procyclical behaviour of interest rates found by empirical studies contradict predictions of macroeconomic theories. This paper incorporates disaggregated measures of investment (residential and nonresidential investment) along with disaggregated measures of money (outside and inside money) into the analysis of the impact of money on economic activity. The Vector Error Correction model is employed to deal with the issues of stationarity and cointegration in the data. Disaggregating money and output produces the expected liquidity effect of money on interest rates and helps to detect the transmission mechanism by which interest rates affect real economic activity. Further, the evidence presented in this paper underscores the importance of Residential Fixed Investment as a major player in explaining the money-output relationship.