Evaluating Monetary Policy Options

Abstract

We present a procedure for evaluating ex ante the effects of alternative paths of a monetary policy tool (the federal funds rate in our illustrations) on output and the price level within a variant of a widely used vector autoregressive model of the U.S. economy. This exercise is a supplement to, or even an alternative to, analysis that relies on a particular structural model. Illustrations of the method are provided by evaluating the effects of changes in the funds rate target. Additionally, the Taylor rule is used to generate target funds rates for different target inflation rates, and the effects of these are evaluated. One of the critical elements in the formulation of monetary policy is the evaluation of the effects of alternative paths of the policy instrument on the macroeconomy. For example, in Federal Open Market Committee (FOMC) meetings, estimates of the effects of alternative paths of the federal funds rate are presented to policymakers as an input into the policy process; for a discussion, see Meulendyke (1998). The effects of the alternative paths are evaluated within the context of a structural model of the economy; the latest version of the structural model used at the Board of Governors is described in Brayton et al. (1997). In this article, we present a procedure for evaluating ex ante the effects of alternative paths of a monetary policy tool (the federal funds rate in our illustrations) on output and the price level. We demonstrate this procedure employing a variant of a widely used vector autoregressive (VAR) model of the U.S. economy. This exercise can be viewed as a supplement to, or even an alternative to, analysis that relies on a particular structural model. Given the lack of general agreement on the appropriate structural model, evaluation of the effects of changes in the policy instrument within a variety of different types of models is appropriate. The discussion of the proposed procedure is in the spirit of recent work by Leeper and Sims (1994), who, following earlier work by Sims (1982, 1987), distinguish between normal policymaking and regime changes. For purposes of illustration, we employ a VAR model comprised of the same variables used by Christiano, Eichenbaum, and Evans (hereafter CEE) (1994, 1996) and Bernanke and Mihov (hereafter BM) (1998). We show how to evaluate and compare the current policy path with normal policy alternatives, such as typically sized changes in the federal funds target. We stress that this model is used only for illustrative purposes. Our methodology applies to any generic structural model and thus can easily