Time series evidence on the money supply process in the USA: A new state space modelling approach

Abstract

The purpose of this paper is to determine empirically whether changes in the Federal Reserve's operating procedures are responsible for important changes in the nature of the money supply and the effects of monetary policy. A new vector modelling procedure which provides an original integration of short-run and long-run dynamics has been adopted. Moreover, the methodology applied in the paper allows correct identification of money supply and money demand shocks. It is found that independently of the existing operating procedure reserves supply is influenced by money demand shocks. This suggests that Federal Reserve operating procedures always involve some degree of interest rate smoothing or ‘money condition policy’. On the other hand, it is found that the influence of money supply shocks which are interpreted as discretionary policy actions vary under different operating procedures. In particular, a liquidity effect is detected only during the 1979–1982 anti-inflationary regime. This indicates that the effectiveness of monetary policy can be detected during episodic events, as it was in the situation in 1979 in which the monetary authority intervened heavily to alter an economic state.