Nonborrowed Reserves Research Articles

Analysis of the Spillover Effect of the US Quantitative Easing Policy on China's Multi-level Bond Market

This paper focuses on the spillover effect of quantitative easing (QE) policy adopted by the United States on China's multi-level bond market under the outbreak of the epidemic in 2020. Since the US launched QE in March 2020 and ended it in October 2021, this paper selects the yields of one-year treasury bonds, financial bonds, and local government bonds in this period to represent different issuers and selects US non-borrowed reserve as an indicator to measure the level of capital overflow. Then, this paper adopts vector autoregressive (VAR) model for empirical analysis. The results of the model represent that the QE has some influence on China’s bond market, and this impact has different effects on the bonds of different issuers. Compared with financial debt and local government debt, national debt is less impacted, and its impact time lags behind others’. The possible reason is that the bonds issued by different issuers have different abilities to bear market risks, so they react in various ways. Finally, based on the research results, this paper puts forward some policy suggestions combined with the current situation.

The FOMC's Committee on the Directive: Behind Volcker's New Operating Procedures

On October 6, 1979, Chairman Volcker announced that the Federal Reserve was embarking on a new, forceful, and ultimately successful campaign to lower the rampant inflation of that time. At the center of this campaign were new operating procedures for conducting monetary policy—procedures that focused daily open market operations on controlling the quantity of monetary reserves and the quantity of nonborrowed reserves in particular. This was a dramatic shift from the prior focus on targeting the federal funds rate. These new operating procedures were preceded by well over a decade of work that was directed by the Federal Open Market Committee (FOMC) and was carried out by its Committee on the Directive (COD). Prior to 1979, the COD had recommended, but then rejected, operating procedures based on controlling nonborrowed reserves. It was the Volcker Fed that accepted and implemented these reserves-based operating procedures, and it did so with the goal of targeting the monetary aggregates to have restrained and stable growth rates.

Delayed overshooting can still be a puzzle after the 1980s

This paper reinvestigates the effects of US monetary policy shocks on exchange rates by using the structural VAR model with sign restrictions imposed on impulse responses following Kim et al. (2017) who documented that a delayed overshooting puzzle was not observed in the post-Volcker era. The main results are as follows. First, a huge uncertainty in the result of the nominal exchange rate response, which is the main variable of interest in Dornbusch’s overshooting theory, can be observed although Kim et al. (2017) investigated mostly the real exchange rate response. Second, the delayed overshooting puzzle for both nominal and real exchange rates is found for the model that includes non-borrowed reserves divided by a lag of total reserves, instead of current total reserves used by Kim et al. (2017), to be consistent with monetary policy operating procedure.

Jamaica: First Review Under the Stand-By Arrangement, Request for Waiver of a Performance Criterion, and Request for Modification of Performance Criteria

This paper discusses Jamaica’s First Review under the Stand-by Arrangement (SBA), Request for Waiver of a Performance Criterion (PC), and Request for Modification of PC. Program implementation remains strong under the SBA. Sustained macroeconomic discipline and visible reforms have boosted stability and confidence. Positive real GDP growth has been recorded in seven consecutive quarters, and Jamaica is projected to grow 2 percent in fiscal year 2017/18, bolstered by construction and tourism, among other factors. Inflation reached an all-time low in 2016, and investor confidence is at an all-time high, attracting foreign direct investment. The current account deficit has narrowed significantly, supporting accumulation of nonborrowed reserves.

Identification of monetary policy shocks: a graphical causal approach

This paper develops a structural VAR methodology based on graphical models to identify the monetary policy shocks and to measure their macroeconomic effects. The advantage of this procedure is to work with testable overidentifying models, whose restrictions are derived by the partial correlations among residuals plus some institutional knowledge. This permits to test some restrictions on the reserve market used in several approaches existing in the literature. The main findings are that neither VAR innovations to federal funds rate nor innovations to nonborrowed reserves are good indicators of monetary policy shocks.

Measuring the Channels of Monetary Policy Transmission: A Factor-Augmented Vector Autoregressive (Favar) Approach

Abstract There is more consensus on the effects of monetary policy than its transmission mechanism. Two channels of transmission mechanisms are the conventional interest rate channel and the credit channel. I investigate the channels of monetary policy transmission in the U.S. using the factor-augmented vector autoregressive (FAVAR) models developed by Bernanke, Boivin & Eliasz (2005). The newly developed FAVAR approach allows the researcher to include all relevant macroeconomic variables in the model and analyze them. Therefore, the FAVAR models span a larger information set and generate better estimates of impulse response functions than the commonly used vector autoregressive (VAR) models that utilize only 4–8 variables. I include 154 monthly U.S. time series variables for the period 1970–2014. The findings support the existence of the credit channel in the U.S. The conclusion remains the same when the non-borrowed reserve operating regime (October 1979–October 1982) is removed from the sample period.

Rethinking the liquidity puzzle: Application of a new measure of the economic money stock

Historically, attempts to solve the liquidity puzzle focus on narrowly defined monetary aggregates, such as non-borrowed reserves, the monetary base, or M1. Many of these efforts fail to find a short-term negative correlation between interest rates and monetary policy innovations. More recent research uses sophisticated macroeconomic and econometric modeling. However, little research has investigated the role measurement error plays in the liquidity puzzle, since in nearly every case, work investigating the liquidity puzzle has used one of the official monetary aggregates, which have been shown to exhibit significant measurement error. In this paper, we examine the role that measurement error plays in the liquidity puzzle by (i) providing a theoretical framework explaining how the official simple-sum methodology can lead to a liquidity puzzle, and (ii) testing for the liquidity effect by estimating an unrestricted VAR.

Are the Effects of Monetary Policy Shocks Big or Small?

This paper studies the estimated effects of monetary policy shocks from standard VAR’s, which are small, and those from the approach of Romer and Romer (2004), which are large. The differences appear to be driven by three factors: a) the contractionary impetus associated with each shock, b) the period of non-borrowed reserves targeting and c) lag length selection. Accounting for these factors, the real effects of monetary policy shocks are consistent across approaches and are most likely medium: a one-hundred basis point innovation to the Federal Funds Rate lowers production by 2-3% and raises the unemployment rate by approximately 0.50% points. In addition, alternative measures of monetary policy shocks from estimated Taylor rules also yield medium-sized real effects and indicate that the historical contribution of monetary policy shocks to real fluctuations has been non-trivial, particularly during the 1970s.

A Back-of-the-Envelope Rule to Identify Atheoretical VARs

Vector autoregressive models are often used in Macroeconomics to draw conclusions about the effects of policy innovations. However, those results depend on the researcher’s priors about the particular ordering of the variables. As an alternative, this paper presents a very simple rule based on the maximum entropy principle that can be used to find the “most likely” ordering. The proposal is illustrated in the case of a VAR model of the U.S. economy. It is found that monetary policy shocks are better represented by innovations in the federal funds rate rather than in non-borrowed reserves.

Identifying Monetary Policy Shocks via Changes in Volatility

A central issue of monetary policy analysis is the specification of monetary policy shocks. In a structural vector autoregressive setting there has been some controversy about which restrictions to use for identifying the shocks because standard theories do not provide enough information to fully identify monetary policy shocks. In fact, to compare different theories it would even be desirable to have over‐identifying restrictions that would make statistical tests of different theories possible. It is pointed out that some progress toward over‐identifying monetary policy shocks can be made by using specific data properties. In particular, it is shown that changes in the volatility of the shocks can be used for identification. Based on monthly U.S. data from 1965 to 1996 different theories are tested and it is found that associating monetary policy shocks with shocks to nonborrowed reserves leads to a particularly strong rejection of the model whereas assuming that the Fed accommodates demand shocks to total reserves cannot be rejected.

Federal Reserve Policy Viewed Through a Money Supply Lens

Federal Reserve nonborrowed reserve supply systematically responded to changes in inflation and in the output gap over the period 1969-2000. While the feedback from output gap is always negative, the response of money supply to changes in inflation varies considerably across time. Nonborrowed reserves decreased with inflation in the post-1979 period and increased in the pre-1979 period. Applying a standard macro-model, the estimated reaction functions are shown to ensure equilibrium determinacy. Viewed through the money supply lens, Federal Reserve policy substantially changed over time, but has never allowed for endogenous fluctuations, which contrasts conclusions drawn from federal funds rate analyses.

Federal reserve policy viewed through a money supply lens

Federal Reserve nonborrowed reserve supply systematically responded to changes in inflation and in the output gap over the period 1969–2000. While the feedback from output gap is always negative, the response of money supply to changes in inflation varies considerably across time. Nonborrowed reserves decreased with inflation in the post-1979 period and increased in the pre-1979 period. Applying a standard macro-model, the estimated reaction functions are shown to ensure equilibrium determinacy. Viewed through the money supply lens, Federal Reserve policy substantially changed over time, but has never allowed for endogenous fluctuations, which contrasts conclusions drawn from federal funds rate analyses.

Identifying Monetary Policy Shocks Via Changes in Volatility

A central issue of monetary policy analysis is the specification of monetary policy shocks. In a structural vector autoregressive setting there has been some controversy about which restrictions to use for identifying the shocks because standard theories do not provide enough information to fully identify monetary policy shocks. In fact, to compare different theories it would even be desirable to have over-identifying restrictions which would make statistical tests of different theories possible. It is pointed out that some progress towards overidentifying monetary policy shocks can be made by using specific data properties. In particular, it is shown that changes in the volatility of the shocks can be used for identification. Based on monthly US data from 1965-1996 different theories are tested and it is found that associating monetary policy shocks with shocks to nonborrowed reserves leads to a particularly strong rejection of the model whereas assuming that the Fed accommodates demand shocks to total reserves cannot be rejected.

A Defence of the Expectations Theory as a Model of US Long Term Interest Rates

This paper re-examines the empirical content of the expectations theory of the term structure by employing the Campbell-Shiller (1987) methodology to study the behaviour of 10-year/three-month US government yield spreads. The methodology is implemented in two ways. First, theoretical spreads satisfying the expectations theory are constructed from in-sample forecasts of future changes in short rates generated from a small-scale VAR. Second, theoretical spreads are computed from out-of-sample forecasts of changes in short rates with the parameters of each VAR equation updated with a Bayesian procedure. When the procedure is restricted to give less weight to new data than would be the case with OLS estimation over an expanding sample, theoretical spreads computed from out-of-sample forecasts track actual spreads closely in pre-1979 data. This is also the case as from the start of 1984 if data from the 1979Q4-1982Q4 period of non-borrowed reserve targeting are given zero weight when estimating the parameters of the VAR. This paper was written while the author, Gregory D. Sutton, was an economist in the Monetary and Economic Department.

What are the effects of monetary policy on output? Results from an agnostic identification procedure

This paper proposes to estimate the effects of monetary policy shocks by a new agnostic method, imposing sign restrictions on the impulse responses of prices, nonborrowed reserves and the federal funds rate in response to a monetary policy shock. No restrictions are imposed on the response of real GDP to answer the key question in the title. I find that “contractionary” monetary policy shocks have no clear effect on real GDP, even though prices move only gradually in response to a monetary policy shock. Neutrality of monetary policy shocks is not inconsistent with the data.

Tests of the expectations hypothesis: Resolving the anomalies when the short-term rate is the federal funds rate

The expectations hypothesis (EH) of the term structure plays an important role in the analysis of monetary policy, where shorter-term rates are assumed to be determined by the market’s expectation for the overnight federal funds rate. With two exceptions, tests using the effective federal funds rate as the short-term rate easily reject the EH. These exceptions are when the EH is tested over the nonborrowed reserve targeting period and when the test is performed only using data for settlement Wednesdays – the last day of bank reserve maintenance period. This paper argues that these exceptions are anomalous: in the former case, the failure to reject the EH occurs when economic analysis suggests that the market should be less able to forecast the federal funds rate. In the latter case, it occurs when there are sharp spikes in the funds rate that cannot improve materially the market’s ability to forecast the funds rate. Additional analysis shows that these anomalous results are a consequence of the procedure used to test the EH.

Monetary Policy, Secrecy, and Federal Funds Rate Behavior

The behavior of the Federal Reserve System can be characterized as secretive with respect to its control of monetary aggregates. One common justification for this secrecy is that markets will overreact to information, causing undue variability in interest rates. However, the consequences of keeping policy objectives hidden has received little formal attention. This paper takes an initial step by examining the variability of the federal funds rate and total reserves under nonborrowed reserve targeting. The major result is that the disclosure of operating procedures will generally increase the unconditional variability of both the funds rate and total reserves, but will decrease the variance of the forecasting error of the federal funds rate.

Evidence-Based Economics

Abstract This paper presents an outline of a methodology of ‘evidence-based economics’. The question whether an economic statement is evidence-based must be answered on three different levels. The first level concerns measurement: it asks whether claims made about economic quantities such as inflation, unemployment, growth or poverty are justified by the data and measurement procedures. The second level concerns induction: it asks whether claims made about the relations between economic quantities (such as ‘number of babies born predicts growth’, ‘change in money causes change in monetary income’, ‘non-borrowed reserves can be used to control the interest rate’), are justified by the inference procedures. The third level concerns idealisation: it asks whether the quantities and relations selected are justified by the stated aim of the inquiry. The paper provides a discussion of these three types of investigation and of some solutions that have been offered.

A revisit to liquidity effects––evidence from a non-linear approach

Although liquidity effects are important to quantitative monetary economics, the empirical support for their existence is controversial in existing literature. Conventional literature applies a linear system to investigate the significance of the liquidity effect. This paper points out the appropriateness of a non-linear framework in examining the existence of the liquidity effect and uncovers its existence for the case of non-borrowed reserves and the federal funds rate.

Chronicle of the Liquidity Effect Foretold

Conventional accounts of the immediate mechanism whereby the Federal Reserve raises short-term interest rates require the Fed to reduce the supply of reserves in order to raise interest rates. This paper shows in popular monetary models that although the Fed can have an immediate effect on interest rates purely by announcing a change in the target without changing reserves, these models imply that by the end of the maintenance period, one should see some combination of a drop in nonborrowed reserves, drop in excess reserves, or increase in borrowed reserves in order to ratify the Fed's intended interest rate hike. Using aggregate reserves of depository institutions data, this paper looks at what happens to various reserve measures during maintenance periods in which there was a change in the Fed funds target. An institutionally motivated time-varying parameter model is built to predict each monetary aggregate. Using three different measures of monetary policy, two of an unanticipated change in the funds target and the change in the target itself, a negative correlation between the target change and what happens to three of the five corresponding reserve aggregates is found. The sign and magnitude of the finding for the target is consistent with the standard results from the literature regarding the liquidity effect. Nevertheless, these results are not replicated when using the proxies for unanticipated changes.