The Effects of Monetary Policy Shocks: Comparing Contemporaneous versus Long-Run Identifying Restrictions

Abstract

This study compares the effects of monetary policy shocks on the macroeconomy using four different procedures for identifying policy shocks that use contemporaneous restrictions and a procedure that uses long-run restrictions. Impulse response functions are computed using the same vector autoregressive (VAR) model and sample period. The comparison is done for a model that includes only a short-term interest rate and for a model that adds a long-term rate as well. Sources of differences in the magnitude of effects across identification schemes are examined. Vector autoregressive (VAR) models have been widely used in recent years to analyze the effects of monetary policy shocks. However, estimates of the macroeconomic effects of monetary policy often differ across studies with regard to both timing and magnitude. The studies generating these estimates frequently differ in terms of the variables constituting the model, the sample period for estimation, and the method of identifying policy shocks (see, e.g., Christiano, Eichenbaum, and Evans 1994, 1996, 1998; Gordon and Leeper 1994; Lastrapes and Selgin 1995; Pagan and Robertson 1995, 1998; Leeper, Sims, and Zha 1996). Certainly, a critical element in the estimation of the effects of policy shocks is the identification of these policy shocks, that is, the determination of exogenous shocks to monetary policy. Two methods have been widely used in the VAR literature to identify structural shocks to monetary policy. One general approach employs restrictions on the contemporaneous relations among the variables of the VAR model, while the second general approach imposes restrictions on the long-run relations among the variables. Although economic and institutional arguments can be used to rationalize each identification scheme, there is no consensus as to which approach to identifying shocks is preferred, and the weaknesses of both approaches have been discussed in the literature.' Keating (1992), Lastrapes and Selgin (1995), and McCarthy (1995) consider limitations of the use of contemporaneous identifying restrictions. Faust and Leeper (1997) discuss potential drawbacks of imposing long-run restrictions. The aim of this study is to examine the implications of contemporaneous versus long-run