Monetary policy shocks: What have we learned and to what end?

This chapter in the 1999 Handbook of Macroeconomics (Volume 1) by Lawrence Christiano, Martin Eichenbaum, and Charles Evans surveys and unifies the VAR-based literature on identifying monetary policy shocks and tracing their dynamic effects on the U.S. economy, comparing multiple identification schemes within a common recursive framework. Using quarterly U.S. data (1965:Q3-1995:Q2) and three benchmark recursive identification schemes — treating the federal funds rate, nonborrowed reserves, or the ratio of nonborrowed to total reserves as the policy instrument — the authors find a robust set of qualitative facts following a contractionary monetary policy shock: the federal funds rate rises persistently, monetary aggregates decline (some with a delay), the price level responds very little for roughly a year before declining, and real GDP falls in a hump-shaped pattern with its maximal decline about one to one-and-a-half years after the shock. They also document and help resolve the “price puzzle” — the anomalous finding that a contractionary shock appears to raise prices — showing it arises from omitting commodity prices (a leading indicator of inflation available to the Fed) from the policy reaction function’s information set, and that including them typically eliminates the puzzle. Comparing the recursive approach against a fully simultaneous (Sims-Zha) identification and against narrative-based measures of policy shocks (Romer-Romer episodes), the chapter concludes that “qualitative inference about the effects of a monetary policy shock is quite robust to the different shock measures,” even though quantitative estimates — particularly the fraction of output variance attributable to policy shocks (ranging from about 7% to 44% at the 4-to-8-quarter horizon depending on the shock measure) — are considerably more sensitive to the specific identification chosen.

Nominal Rigidities and the Dynamic Effects of a Shock to Monetary Policy

This 2005 Journal of Political Economy paper by Christiano, Eichenbaum, and Evans (CEE) builds and estimates a general-equilibrium model to answer a specific question: what combination of frictions lets a DSGE model reproduce two features economists had already documented in the data - an inertial response of inflation and a persistent, hump-shaped response of output - after a shock to monetary policy? Rather than picking parameters to match a few moments, CEE identify the monetary policy shock as the seventh element (ordered after prices, output, consumption, investment, the real wage, and labor productivity, but before profits and M2 growth) of the Cholesky-orthogonalized innovations to a nine-variable recursive VAR estimated on quarterly U.S. data from 1965Q3 to 1995Q3, then estimate a subset of the model’s structural parameters by minimum-distance matching of the model’s impulse responses to the first 25 periods of the VAR-implied impulse responses. The model combines Calvo price contracts with lagged-inflation indexation for firms that cannot reoptimize, Calvo wage contracts with analogous lagged-inflation indexation for households, habit formation in consumption, convex costs of adjusting the flow of investment, variable capital utilization, and a working-capital channel through which firms borrow to finance their wage bill in advance, so that the nominal interest rate enters marginal cost directly. The estimated benchmark model puts the average price contract at about 2.5 quarters (Calvo parameter 0.60) and the average wage contract at about 2.8 quarters (0.64), with habit parameter 0.65 and an investment-adjustment-cost parameter implying a temporary 1 percent increase in the price of capital raises investment by 0.40 percent; the capital-utilization curvature parameter is driven to its lower bound of 0.01, indicating a highly elastic supply of capital services. With these parameters, the model’s impulse responses lie within the two-standard-deviation confidence bands of the VAR-estimated responses for most variables: inflation shows no noticeable rise until roughly three years after an expansionary shock, output rises for nine quarters with a cumulative response of 3.14 percent, of which more than 78 percent occurs after the typical wage and price contract in effect at the time of the shock has been reoptimized (a “contract multiplier” of 3.7). Counterfactual re-estimations show sticky wages, not sticky prices, are the crucial nominal friction - setting price stickiness to zero barely affects the estimated wage-contract length or the model’s qualitative fit, while setting wage stickiness to zero forces price stickiness to an extreme (contracts averaging over three years, which the authors call inconsistent with microeconomic evidence) and destroys the hump-shaped output response - and that variable capital utilization is the crucial real friction, since removing it roughly halves the output response and again forces implausibly long price contracts when re-estimated. The paper is explicit that its results are estimated on a single U.S. sample ending in 1995Q3, that Calvo pricing is treated as a reduced-form device for nominal sluggishness rather than a literal description of contracting, and that the model is disciplined only against monetary-policy-shock responses, leaving its performance against other shocks as a separate, only preliminarily addressed question.

Charles L. Evans | Macro Paper Warehouse

Monetary policy shocks: What have we learned and to what end?

Nominal Rigidities and the Dynamic Effects of a Shock to Monetary Policy