Assessing Changes in the Monetary Transmission Mechanism: A VAR Approach

This 2002 FRBNY Economic Policy Review paper by Jean Boivin and Marc Giannoni asks whether the transmission of monetary policy shocks to U.S. output and inflation changed after the early 1980s, and if so, whether the change reflects a shift in the propagation mechanism (how shocks work their way through the economy), a change in the size of shocks hitting the economy, or specifically a change in how the Federal Reserve systematically conducts policy. Using quarterly U.S. data from 1963:Q1 to 1997:Q4 on detrended output (a high-pass filter approximating the output gap), GDP-deflator inflation, commodity-price inflation (added to limit the price puzzle), and the federal funds rate, the authors estimate a four-variable, four-lag recursive (Cholesky) VAR in the Christiano-Eichenbaum-Evans (1999) style, ordering the funds rate last so it does not affect the other variables contemporaneously, and split the sample into pre-1980 (1963:Q1-1979:Q3), post-1980 (1980:Q1-1997:Q4), and post-1984 (1984:Q1-1997:Q4, excluding the 1979:Q4-1983:Q4 nonborrowed-reserves-targeting episode) sub-periods around the Volcker (1979:Q4) and McConnell-Perez-Quiros Great Moderation (1984:Q1) break dates. Andrews sup-Wald tests reject stability of the reduced-form VAR coefficients in 6 of 16 tests (38%), and chi-squared tests reject stability of the innovation covariance matrix in 5 of 8 tests overall (63%, pooling both break dates) — rejecting in all 4 of 4 variables at the 1979:Q3 break but only 1 of 4 at the 1984:Q1 break, indicating pervasive instability in both the propagation mechanism and shock variances. A reduced-form counterfactual variance decomposition finds that changed propagation coefficients account for roughly 38% (pre- vs. post-1980) or 22% (pre- vs. post-1984) of the decline in detrended-output variance, and roughly 58% (pre- vs. post-1980) or 56% (pre- vs. post-1984) of the decline in inflation variance, with the remainder attributed to reduced shock variance; the authors’ own rounded headline figures (“roughly 40 percent” for output, “60 percent” for inflation) refer specifically to the pre- vs. post-1980 comparison. Structural variance decompositions show monetary policy shocks’ contribution to output variance falling from 19% (pre-1980) to 7% (post-1980) to 3% (post-1984), and to inflation variance from 14% to 10% to 6%, even though the estimated variance of the policy shock itself is larger in the post-1980 sample (0.61 vs. 0.30 pre-1980, attributed to the 1979-83 nonborrowed-reserves episode) before falling to 0.14 post-1984 – suggesting the change concerns how policy shocks propagate, not merely their size. Impulse responses to an unexpected 1-percentage-point (100-basis-point) funds-rate increase are “much less pronounced and persistent” after 1980, with the output response trough “more than twice as large” pre-1980 as in either later sample. The paper’s central counterfactual then separates the model’s coefficients into a systematic-policy-rule block (denoted Phi) and a rest-of-economy block (denoted Omega), finding that replacing only the pre-1980 policy rule with the post-period rule (holding Omega fixed) reproduces the post-period impulse responses closely, whereas replacing only Omega “changes only little” – leading the authors to conclude that most of the reduction in output and inflation responses is accounted for by a change in the parameters characterizing systematic monetary policy. Via a simple IS-curve model they interpret this as more consistent with a more aggressive, stabilizing policy rule than with a genuine weakening of the interest-rate transmission channel, while explicitly noting that the VAR counterfactual alone cannot separately identify the two.

Marc Giannoni | Macro Paper Warehouse

Assessing Changes in the Monetary Transmission Mechanism: A VAR Approach