Wavelet Multiresolution Analysis of the Liquidity Effect and Monetary Neutrality

Abstract

This paper employs the maximum overlap discrete wavelet transform to obtain timescale decompositions of monetary aggregates, short-term interest rates and output to investigate two propositions in monetary economics: the liquidity effect and the long-run neutrality of money. Evidence from correlation and Granger causality over five timescales suggests that the liquidity effect is statistically significant in both the US and Sweden’s economies, with a shorter time horizon in the US than in Sweden. There is no evidence of monetary neutrality in both economies; at finest timescales, output Granger causes money in Sweden, whereas it is the other way around in the US. At long time horizons, there is a feedback between money and output in both economies. Key to our findings is that monetary disturbances have significant real effects and these effects last longer than it is assumed in real business cycle models.