Identifying Monetary Policy in a Small Open Economy under Flexible Exchange Rates

This 1997 Journal of Monetary Economics paper by David Cushman and Tao Zha addresses the “exchange rate puzzle” and “price puzzle” that plague conventional recursive (Choleski) VAR studies of monetary policy in small open economies – where a contractionary domestic interest-rate shock perversely depreciates the currency and raises prices – by arguing these puzzles “derive from an identification of monetary policy that is inappropriate for such economies,” specifically the recursive ordering’s implicit assumption that the central bank cannot respond contemporaneously to the exchange rate, which is inconsistent with how a small-open-economy central bank like the Bank of Canada actually behaves. Using monthly Canada-US data from 1974-1993 (chosen to avoid the 1973 oil shock and the pre-float period) with 12 lags, the authors estimate a non-recursive structural VAR with block exogeneity, treating the US block (output, prices, the federal funds rate, and a world commodity price index) as exogenous to Canada while specifying the Canadian block’s contemporaneous structure across three sectors: a money market (a money-demand equation plus a policy reaction function that lets policy respond within the month to the exchange rate, the Canadian money stock, the foreign interest rate, and commodity prices), an information market (an exchange-rate equation responding to all eleven contemporaneous variables), and a recursively-ordered production sector (imports, exports, output, prices) excluded from contemporaneous foreign and financial influences. Estimated by maximum likelihood with Monte Carlo error bands (Zha 1996 method) and passing a model-stability test (chi-square(364) = 346.1), the identification eliminates both puzzles: a contractionary monetary policy shock produces an immediate, persistent decline in M1, an immediate and significant appreciation of the Canadian dollar lasting about 12 months, only a brief and small rise in the nominal interest rate, and a gradual, non-puzzling decline in the price level. Transmission operates primarily through the exchange rate rather than the interest rate – in contrast to the strong interest-rate effects found in US studies such as Gordon and Leeper (1994) – with a J-curve pattern in the trade balance (imports down roughly 0.5% by month 4) and approximate uncovered interest parity (UIP deviations significant for only about 4 months). Forecast-error variance decompositions show monetary policy shocks explain a small share of Canadian output variance – about 1.00% at 12 months, no more than 2.75% at any horizon up to 6 months – with the production and information sectors dominating in the first few months and foreign shocks becoming dominant after 12 months (roughly 72-74% of output variance at 12, 24, and 48 months), a result the authors caution does not imply that endogenous monetary policy itself is ineffective.

What Does Monetary Policy Do?

This 1996 Brookings Papers on Economic Activity paper by Eric Leeper, Christopher Sims, and Tao Zha asks what monetary policy actually does, and argues that the answer the identified-VAR literature had been giving was fragile because different papers used different samples, variable sets, and identification schemes; the authors instead estimate an escalating sequence of Bayesian structural VARs – first small 4- and 5-6-variable systems that reinterpret existing recursive and non-recursive identifications (Strongin’s NBR/TR system, Christiano-Eichenbaum-Evans’s NBR system), then integrated 13- and 18-variable systems – all on one common monthly U.S. data set (January 1960-March 1996, six lags, quarterly series interpolated via Chow-Lin) so that conflicting conclusions can be checked for robustness on equal footing. Identification proceeds through a mix of exact zero restrictions, probabilistic (“soft-zero”) priors, and informal plausibility screening on impulse responses, organized around a sectoral block structure that splits variables into slow-moving private (“P”), fast-moving auction-market information (“I”), Federal Reserve policy (“F”), and banking (“B”) blocks, with the Fed’s reaction function restricted to respond within the month only to fast-moving financial information, not to CPI or GDP (which are measured with a lag); estimation uses a Bayesian “reference prior” (Sims-Zha) that downweights explosive, poorly-identified dynamics, and published error bands are 68% (about one standard error) probability bands from posterior simulation, not classical confidence intervals. Across the model sequence, a policy-tightening shock in the integrated 13- and 18-variable systems produces a broadly coherent contractionary picture – short and long rates rise, reserves and M1 fall smoothly, output and its components fall, unemployment rises, commodity prices fall, and the dollar appreciates – but the CPI response is very small (briefly slightly positive, only weakly negative after several years), and policy shocks account for only a modest share of output and (in the 13-variable model) a “negligible” share of CPI variance, while a separate private-sector shock – one the model allocates to the private sector with nothing in its estimated form suggesting misallocation, and which the authors judge it “unlikely” is “mistakenly incorporat[ing] much of an expansionary monetary policy disturbance” – is nonetheless the dominant source of M1 and reserves variation, showing that most of the observed variation in these aggregates is genuinely nonpolicy in origin and so is unsatisfactory as a one-dimensional policy indicator. Specifications that imply large real effects of policy (notably Strongin’s NBR/TR system, where policy shocks explain about half of output variance at three-plus-year horizons) tend to come bundled with an implausible sustained price-level rise after a contraction (a severe price puzzle), which the authors read as a sign of policy misspecification rather than a genuine large policy effect; the CEE NBR system, by contrast, produces believable but small real effects. The authors’ robust cross-specification conclusions are that only a modest portion (sometimes essentially none) of U.S. output and price variance since 1960 traces to monetary policy shocks, that most of the observed variation in policy instruments and monetary aggregates is the systematic, endogenous response of policy to the state of the economy rather than exogenous disturbance, that treating reserves or a monetary aggregate as moving mainly in response to policy is therefore unreliable, and that specifications implying large real effects tend to be exactly the ones with implausible price responses. The authors caution that their identified policy shocks may still be absorbing some adverse-supply-shock variation (which would understate price effects and overstate output effects), that the published hard-zero restrictions are a computationally tractable substitute for soft-zero priors the authors initially found more plausible, and that with small changes in specification a shock formally labeled “monetary policy” can rotate into an information-sector shock and vice versa – a fragility warning central to the paper’s message.

Tao Zha | Macro Paper Warehouse

Identifying Monetary Policy in a Small Open Economy under Flexible Exchange Rates

What Does Monetary Policy Do?