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Abstract: 
This paper examines the dynamic relationship between changes in the funds rate
and nonborrowed reserves within a reduced form framework that allows the
relationship to have two distinct patterns over time. A regime switching model
a la Hamilton (1989) is estimated. On average, CPI inflation has been
significantly higher in the regime characterized by large and volatile changes
in funds rate. Innovations in money growth are associated with a strong
anticipated inflation effect in this high inflation regime, and a moderate
liquidity effect in the low inflation regime. Furthermore, an identical money
innovation generates a much bigger increase in the interest rate during a
transition period from the low to high inflation regime than during a steady
high inflation period. This accords well with economic intuition since the
transition period is when the anticipated inflation effect initially gets
incorporated into the interest rate. The converse also holds. That is, the
liquidity effect becomes stronger when the economy leaves a high inflation
regime period and enters a low inflation regime period.
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