Risk-Adjusted Money Demand and Implicit Price Level Dynamics: Responses to Unconventional Monetary Policy During the Subprime Crisis
Date
2025
Authors
Kairuz, Tomás
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García-Cicco, Javier
Journal Title
Journal ISSN
Volume Title
Publisher
Universidad de San Andrés. Departamento de Economía
Abstract
This thesis aims to examine why the Federal Reserve’s response to the 2008 financial
crisis, known as quantitative easing, did not generate an inflation burst in the United States, by incorporating liquidity and default risk components into the traditional money demand relationship. Using the analytical framework presented by Choi (2007), we extend his work to study the model’s behavior during the crisis and subsequent years. Our analysis employs the Johansen test and complements it with the Engle-Granger test, determining the need to incorporate linear and quadratic trends into Choi’s model. We then proceed to make money demand predictions using the long-run relationship predicted by both the traditional and risk-adjusted models, using DOLS and VECM with monthly data from January 1974 to June 2019, taking September 2007 as the crisis starting point. Results show that both the traditional money demand model and the risk-adjusted model predicted an increase in money demand following the crisis, with the second model showing a higher increase. This increase in predicted money demand implies an implicit price level lower than observed. The gap between estimated money demand and observed monetary supply only narrows once the first phase of the Fed’s response (QE1) is implemented, indicating in principle that liquidity was provided to agents facing this increase in their demand. We also observe that money demand estimated with the risk framework provided better estimations throughout the series than the traditional model. Finally, focusing on the model with liquidity and default risk components, we study whether the crisis generated changes in the elasticities of each model component and observe an increase in the magnitude of the liquidity risk term and a decrease in the opportunity cost and output component terms, as well as a sign reversal in the default risk case.
Description
Fil: Kairuz, Tomás. Universidad de San Andrés. Departamento de Economía; Argentina.