Money Supply, Reaction Functions, Financial Markets and Macroeconomic Conditions

Abstract

Monetary policy is a key driver of financial markets. The effects on financial markets are evident, not only around changes in monetary policy or Fed’s announcements but also, indirectly, around macroeconomic data releases, political events, international issues, and the “news”. The impact of inflation surprises on financial markets has an enormous effect over the past years, due to the high liquidity, low investment, and weak economic growth of the real sector of the economy. Investors, analysts, forecasters, economists, and policymakers have a keen interest in understanding how monetary policy and conditions in financial markets (Wall Street) affect economic activity (Main Street). To test this issue empirically, we can compare the current level of the central bank’s policy rate (federal funds rate) by using an augmenting reaction function and with a hypothetical neutral or expected or optimal interest rate. If the federal funds rate is excessively below its neutral (optimal) level, this indicates that monetary policy is ineffective, and it is the one that has caused the bubbles in the markets and the inflation. According to many estimates, this is lately, since 2008, the case for the U.S. economy.