A New Measure of Monetary Policy Shocks: Derivation and Implications

University Of California-Berkeley, Berkeley CA

Investigators

Abstract

Understanding the effects of monetary policy on the economy is important for both basic academic research in macroeconomics and the practical conduct of monetary policy. The proposed research will develop a new measure of monetary policy shocks and use it to study the impact of policy. Existing measures of monetary policy such as the change in the federal funds rate, include changes stemming from sources other than deliberate policy moves. They also include policy changes the Federal Reserve made in response to information about likely economic developments. Because of these features, estimates of the effects of policy that rely on existing measures may be misleading. For example, if the Federal Reserve typically reduces interest rates when it has information that other forces are acting to reduce future output, estimates of the effects of policy that rely on measures of interest rates are likely to understate the impact of policy on output. The proposed research will address these limitations of the existing policy measures in two steps. First, a series for changes in the Federal Reserve's intended federal funds rate around meeting times of the Federal Open Market Committee (FOMC) will be derived frown the narrative records of the FOMC and the quantitative reports of the open market desk of the Federal Reserve Bank of New York. In periods when the FOMC was targeting the funds rate closely, this series will correspond to changes in the target rate made in connection win FOMC meetings. In other periods, the series will reflect the FOMC's beliefs about the expected consequences for the funds rate of its policy actions. Second, and crucially, the Federal Reserve's economic forecasts made shortly before FOMC meetings will be used to eliminate the component of changes in the Federal Reserve's intended federal funds rate that represents responses to information about likely economic developments. Thus, the resulting series for monetary policy shocks will reflect changes in the intended funds rate around FOMC meetings that were not taken in response to information about the expected path of the economy. The research will proceed to use the new measure of policy shocks to examine the impact of policy on the economy. The basic issues that will be investigated are the speed, magnitude, and time pattern of the responses of real activity and inflation to policy. In addition, the research will compare the responses estimated using the new policy measure with responses estimated using broader measures, such as the actual funds rate, to address the question of whether the broader measures yield biased estimates of the effects of policy. Additional portions of the research will use the new measure of monetary policy shocks to study the monetary transmission mechanism and use alternative statistical methods to examine the implications of the new policy measure for the impact of policy on output and inflation.