Different monetary aggregates covary very differently with short term nominal interest rates. Broad monetary aggregates like Ml and the monetary base covary positively with current and future values of short term interest rates. In contrast, the nonborrowed reserves of banks covary negatively with current and future interest rates. Observations like this 'sign switch' lie at the core of recent debates about the effects of monetary policy actions on short term interest rates. This paper develops a general equilibrium monetary business cycle model which is consistent with these facts. Our basic explanation of the 'sign switch' is that movements in nonborrowed reserves are dominated by exogenous shocks to monetary policy, while movements in the base and Ml are dominated by endogenous responses to non-policy shocks.

This paper reports some empirical evidence on the relation between the expected real interest rate and monetary aggregates in postwar U.S. data. We find some evidence against the hypothesis, implied by the Real Business Cycle model of Litterman and Weiss (1985), that the expected real interest rate follows a univariate autoregressive process, not Granger-caused by monetary aggregates. Our findings, however, are consistent with a more general bivariate model--suggested by what Barro (1987, Chapter 5) refers to as "the basic market-clearing model"--in which the real rate depends on its own lagged values and on lagged output. Taking this bivariate model as our null hypothesis, we find no evidence that money-stock changes have a significant liquidity effect on the expected real interest rate.