Monetary Policy and Market Interest Rates

Abstract

This thesis contains four chapters, each of which examines different aspects of the uncertainty facing monetary policymakers.''Monetary policy and market interest rates'' investigates how interest rates set on financial markets respond to policy actions taken by the monetary authorities. The reaction of market rates is shown to depend crucially on market participants' interpretation of the factors underlying the policy move. These theoretical predictions find support in an empirical analysis of the U.S. financial markets.''Predicting monetary policy using federal funds futures prices'' examines how prices of federal funds futures contracts can be used to predict policy moves by the Federal Reserve. Although the futures prices exhibit systematic variation across trading days and calendar months, they are shown to be fairly successful in predicting the federal funds rate target that will prevailafter the next meeting of the Federal Open Market Committee from 1994 to 1998.''Monetary policy with uncertain parameters'' examines the effects of parameter uncertainty on the optimal monetary policy strategy. Under certain parameter configurations, increasing uncertainty is shown to lead to more aggressive policy, in contrast to the accepted wisdom.''Should central banks be more aggressive?'' examines why a certain class of monetary policy models leads to more aggressive policy prescriptions than what is observed in reality. These counterfactual results are shown to be due to model restrictions rather than central banks being too cautious in their policy behavior. An unrestricted model, taking the dynamics of the economy and multiplicative parameter uncertainty into account, leads to optimal policy prescriptions which are very close to observed Federal Reserve behavior.