Measuring Monetary Policy

Bernanke and Mihov (1998, QJE) address a measurement problem in the monetary-VAR literature: the era’s dominant methods for extracting a “monetary policy shock” – Cholesky orderings built around the federal funds rate (FFR), nonborrowed reserves (NBR), or the ratio of nonborrowed to total reserves (NBR/TR, following Strongin 1995) – impose ad hoc restrictions rather than an explicit model of how the Fed actually operates in the market for bank reserves. The paper builds a “semi-structural” six-variable VAR (total reserves, nonborrowed reserves, and the federal funds rate in a policy block; real GDP, the GDP deflator, and a commodity price index in a block-exogenous macro block) over monthly U.S. data, 1965:1-1996:12, with lag length chosen by a general-to-specific procedure (13 lags retained for the full sample). Within the policy block they specify structural equations for reserves demand, borrowed-reserves supply, and the Fed’s nonborrowed-reserves supply/policy rule, estimated by two-step efficient GMM using the reduced-form VAR residuals; this yields five nested identifications – FFR, NBR, NBR/TR, borrowed-reserves (BR), and a just-identified (JI) benchmark that restricts only the reserves-demand elasticity to zero – each corresponding to different assumptions about how much the Fed accommodates reserves-demand shocks (phi^d) and borrowing shocks (phi^b). Overidentifying-restriction tests reject the NBR model in every subsample except the 1979:10-1982:10 Volcker NBR-targeting episode, favor NBR/TR as the best overall fit across subsamples, and favor FFR pre-1979 and post-1988; a Hamilton (1989) regime-switching model applied directly to (phi^d, phi^b) independently locates two structural breaks matching the conventional 1979/1982 Volcker-experiment dates, with phi^d falling from roughly 0.86 outside that window to roughly 0.18 within it. Although the five identifications generate qualitatively similar impulse responses (output rising with a 12-18 month peak, prices moving more slowly and persistently), they diverge sharply in magnitude – the cumulative output response under NBR/TR is more than twice as large as under NBR, and at a four-year horizon the price response under NBR is roughly four times that under FFR – because, the authors show algebraically, any overidentified indicator is a contaminated mixture of the true policy shock with reserves-demand and borrowing shocks whenever the Fed accommodates those shocks. This contamination framework offers an explanation for the post-1984 “vanishing liquidity effect” as a measurement artifact of using the NBR indicator rather than a change in the economy: a derived bias formula, evaluated at the JI model’s full-sample GMM estimates, is negative in the full sample (bias term -0.777) and grows more negative in 1988-1996 (-0.904) and 1984-1996 (-1.035, where it flips the estimated liquidity effect’s sign). The paper closes by constructing an overall monetary-policy-stance index from the full vector of structural innovations, normalized by a 36-month moving average, which correlates 0.71 (monthly) with the Boschen-Mills (1991) index; the authors caution that the empirical illustrations are meant only to be illustrative, since the Figure II impulse responses pool full-sample JI parameter estimates across regimes that the paper’s own regime-switching results show are unstable.

Ilian Mihov | Macro Paper Warehouse

Measuring Monetary Policy