Abstract

This paper develops a structural VAR methodology based on graphical models to identify the monetary policy shocks and to measure their macroeconomic effects. The advantage of this procedure is to work with testable overidentifying models, whose restrictions are derived by the partial correlations among residuals plus some institutional knowledge. This permits to test some restrictions on the reserve market used in several approaches existing in the literature. The main findings are that neither VAR innovations to federal funds rate nor innovations to nonborrowed reserves are good indicators of monetary policy shocks.

Highlights

  • A monetary policy shock is the portion of variation in central bank policy, that is not caused by the systematic responses to variations in the state of the economy

  • Since the crucial issue to identify a Vector Autoregressive (VAR) is to differentiate between correlation and causation, graphical models permitted to impose overidentifying restrictions on the contemporaneous causal structure, in particular on the relationships among macroeconomic variables and between macroeconomic variables and policy variables

  • Once we have narrowed the set of possible contemporaneous causal relationships among the variables which constitute the VAR, we have imposed restrictions derived from institutional and theoretical knowledge

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Summary

Introduction

A monetary policy shock is the portion of variation in central bank policy, that is not caused by the systematic responses to variations in the state of the economy. It is an exogenous shock, which may reflect innovations to the preferences of the members of the monetary authority (e.g. Federal Open Market Committee), measurement errors of the same members, and any other conceivable variation orthogonal to macroeconomic innovations. Vector Autoregressive (VAR) models have been extensively used to isolate and study the effects of a monetary policy shock. To study the dynamic effects of a monetary policy innovation, one needs an “identified” model, namely a model that has an economic interpretation.

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