Academic journal article Contemporary Economic Policy

The Instability in the Monetary Policy Reaction Function and the Estimation of Monetary Policy Shocks

Academic journal article Contemporary Economic Policy

The Instability in the Monetary Policy Reaction Function and the Estimation of Monetary Policy Shocks

Article excerpt

We extend Romer and Romer 's (2004) analysis of the estimation and the effects of monetary policy shocks by controlling for (1) changes in the monetary policy reaction function and (2) changes in the response of output and prices over time with an extended data set. The results suggest that the post 1979 responses of output and prices to a monetary policy shock are significantly different from what has been reported for the whole sample: While output and prices respond significantly and negatively if their response is estimated for the whole sample period (1969-2005), the response of output is insignificant for the period of1979-2005, and the response of prices is much weaker. The analysis of the changes in the monetary policy conducted over time allows us to partly attribute the diminished price and output responses to a successful monetary policy which led to a less volatile economy during the great moderation. (JEL E52, E32, C50)

I. INTRODUCTION

Monetary policy is not exogenously given, but largely driven by policy makers' reactions to macroeconomic conditions. (1) A statement about the impact of monetary policy can thus only be made if it is possible to estimate its component which does not endogenously respond to changes in the macroeconomic environment. To overcome this problem of endogeneity, different approaches have been proposed. One notable approach is the identification of monetary policy shocks by Romer and Romer (2004), who derive their measure of monetary policy shocks by regressing changes in the intended federal funds rate on Greenbook forecasts of output growth, inflation, and the unemployment rate for every regular Federal Open Market Committee (FOMC) meeting in the period between 1969 and 1996. (2) The residuals from this regression are the changes in the federal funds rate target not taken in response to information about future economic developments and thus constitute a measure of monetary policy shocks.

The results of Romer and Romer's analysis are appealing from a theoretical point of view: the "price puzzle," i.e., the positive response of prices to a monetary policy shock disappears, and output temporarily declines in response to a contractionary monetary policy shock. However, their work is based on two simplifying assumptions: firstly, they assume that monetary policy makers' response to movements in inflation and output has not changed for the whole sample, and secondly, that the response of prices and output to monetary policy shocks remained the same over time. These assumptions contradict the recent literature which finds evidence of both a change in the monetary policy reac-fion function (3) and a change in the response of output and prices to monetary policy shocks4 within the examined period.

In this paper, we extend Romer and Romer's (2004) analysis of the impact of monetary policy on output and prices by (1) accounting for the fact that monetary policy makers' response to macroeconomic conditions has changed since Paul Volcker took over the chairmanship of the Federal Reserve in 1979, and (2) recognizing that the macroeconomic stability experienced in the United States after 1979 might have changed the response of output and prices to monetary policy shocks. After providing econometric evidence for a break in the monetary policy reaction function, we use Romer and Romer's methodology to derive monetary policy shocks for the pre-1979 and post-1979 periods by estimating different monetary policy reaction functions for both sample periods. We then show that the response of output and prices to a monetary policy shock has changed significantly around 1980. Based on the results, we are then able to attribute the changes in the price and output responses to changes in the conduct of monetary policy.

Our findings suggest that ignoring the instability in the monetary policy reaction function can provide misleading conclusions about the effects of monetary policy for the whole sample. …

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