Structuring a Money Market Model for Fiscal Policy Analysis

Abstract

One of the principal uses for the Bureau of Economic Analysis (BEA) quarterly econometric model of the U.S. economy is the analysis of alternative fiscal policies. Because multiplier analyses of the BEA model structure indicate that monetary policy variables exert a significant quantitative impact, analyses of the impact of alternative fiscal policies depend critically on the values of the monetary policy variables [3]. The Federal Reserve System (FRS) has actively responded to changes in economic conditions in setting these monetary policy variables. Therefore, to obtain an internally consistent analysis of alternative fiscal policies, FRS reaction to the changes in basic economic conditions generated by these alternative policies should be included in the analysis. The money market subsectors of econometric models typically are constructed as though the level of nonborrowed reserves were the key variable controlled by the FRS. This construction is supported superficially by the fact that open market operations-the most important tool of monetary policy-exert a direct impact on nonborrowed reserves. Nevertheless, the usefulness of the typical money market model is reduced by the unavoidable difficulty of projecting the implementation of FRS policy in terms of a path to be followed by nonborrowed reserves and by the difficulty of linking projected changes in nonborrowed reserves to short-term interest rates.