Academic journal article Journal of Money, Credit & Banking

Asymmetric Monetary Effects on Interest Rates across Monetary Policy Stances

Academic journal article Journal of Money, Credit & Banking

Asymmetric Monetary Effects on Interest Rates across Monetary Policy Stances

Article excerpt

RECENTLY THERE HAS BEEN a great deal of work on the construction of empirical measures for exogenous monetary shocks and on the empirical modeling of monetary policy effects. Extending the empirical literature on the effects of monetary policy on interest rates in a new direction, this paper investigates how the dynamic response of interest rates to a monetary shock varies with the state of the monetary policy stance, which is assigned to one of the three regimes: tight, neutral, and loose. Unlike the conventional reduced-form approach that assumes invariant parameters to monetary policy, we examine a regime-dependent, reduced-form model in which coefficients change over regimes, keeping in mind that agents' reactions to varying policy actions alter coefficients in the reduced form.

The Federal Reserve ("the Fed"), concerned about movements in goal variables such as unemployment and inflation, may not respond to temporary, reversible aberrations in those variables, but it will respond to movements indicative of a lasting change in economic conditions. If aberrations in the variables last for several periods, the corresponding response by the Fed implies a serial correlation in the policy pattern. Agents may expect successive tight positions of the Fed during booms or inflationary periods, whereas they expect no active intervention by the Fed unless the economy shows significant deviations from its norm. Thus, agents will react to monetary changes perceived as driven by the Fed's desire to pursue countercyclical policy only under an interventionist (tight or loose) regime, at least in part by adjusting their inflation expectations. These reactions to policy will result in varying monetary effects across regimes. Desire to verify whether this idea is supported by data motivates the present paper.(1)

In the literature on monetary effects on interest rates, evidence for the presence of the dominating liquidity effect--a short-run negative relationship between money growth and interest rates--is mixed depending on sample period. The dominating liquidity effect in the short run, unquestioned in the 1960s and the early 1970s (Friedman 1968; Cagan and Gandolfi 1969), was no longer evident in later studies which examined the experiences of the 1970s with persistent inflation (Melvin 1983; Reichenstein 1987). More recent studies suggest that monetary effects on interest rates depend on the forecastability of inflation and the identification of shocks. Specifically, (i) the expected inflation or Fisher effect dominates when inflation is largely forecastable (Barsky 1987; Cochrane 1989; Mishkin 1992); (ii) anticipated and unanticipated money supply shocks generate the Fisher and (pure) liquidity effects, respectively, in monetary general equilibrium models (Lucas 1990; Fuerst 1992; Christiano and Eichenbaum 1992); and (iii) shocks in the nonborrowed reserves (NBR)-based measure, reflecting exogenous money supply shocks, exhibit a persistent, dominating liquidity effect, whereas those in the monetary base (MB), M1, or M2 may fail to do so because they involve endogenous responses to nonpolicy shocks such as demand shocks due to interest rate smoothing by the Fed or financial sector shocks (Bernanke and Blinder 1992; Strongin 1995; Chari, Christiano, and Eichenbaum 1995; Bernanke and Milhov 1998; Christiano, Eichenbaum, and Evans 1996). On the other hand, there have been studies examining how monetary effects appear different under different monetary targeting procedures (Leeper and Gordon 1992; Strongin 1995). Viewed overall, these studies imply that an exogenous (and unanticipated) money supply shock generates transitory persistency in the dominating liquidity effect. The existing literature based on a reduced-form analysis, however, has not accounted for the role of agents' reactions in assessing monetary effects on interest rates.

This paper, explicitly emphasizing the role of agents' reactions to policy, empirically explores whether monetary effects on interest rates differ across regimes in the following steps. …

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