A New Approach to Estimate the Effects of Conventional and Unconventional Monetary Policy

Project overview

This research project builds upon a large amount of literature that already exists in this subject area, especially following Lucas’ critique, which studies the effects of policy changes by estimating the impact of exogenous policy shocks. However, this project has identified a new procedure that looks at economic shocks as exogenous shifts in a function, which the researchers refer to as “functional shocks”. This is different to what has already been presented in the existing literature. Therefore, this research project has proposed an entirely new way to think about the transmission of policies on the economy. The researchers show how to identify such shocks and how to trace their effects in the economy via VARs using two new techniques: “VARs with functional shocks” and “functional Local Projections.”

Summary, output, and dissemination

Research summary

With the use of new procedures that have been created by the researchers, they address the crucial question of studying the effects of monetary policy by identifying monetary policy shocks as shifts in the whole term structure of government bond yields in a narrow window of time around monetary policy announcements. Understanding how unconventional monetary policy affects the economy is a crucial task that provides important guidance to policymakers.

This approach sheds new light on the effects of monetary policy shocks, both in conventional and unconventional periods, and shows that traditional identification procedures may miss important effects. This new procedure has the advantage of identifying monetary policy shocks during both conventional and unconventional monetary policy periods in a unified manner and can be applied more generally to other economic shocks.

The researchers found three different results from this project:

1. A novel theoretical framework was developed to estimate the effects of economic shocks. In particular, two new estimators were proposed: a “VAR with functional shocks” procedure and the second, a “functional local projection” (FLP) approach, which can also allow instrumental variables. This provides a new set of tools for researchers and practitioners.

2. Using the new framework, the researchers empirically studied the effects of unconventional monetary policy. Unconventional monetary policy is a new approach that central banks adopted during the latest financial crises, where interest rates hit the zero lower bound and could not be lowered further. Our definition of a monetary policy shock is a shift in the entire term structure of interest rates in a short window of time around central banks' monetary policy announcement dates. Clearly, the entire term structure contains important information on the duration of the zero lower bound episode and on the expected effects of monetary policy. Hence, the definition presented in this research, of monetary policy shocks is broader than that used in the existing literature, which typically uses exogenous changes in the short-term interest rate alone, and has the potential to encompass more broadly other changes that monetary policy has on both short- and long-term interest rates. Such announcement effects are associated with forward guidance or quantitative easing. While a lot is known about the effects of monetary policy during conventional times (at times in which the monetary authority can freely change the short-term interest rate or money supply) much less is known about the effects of monetary policy during zero lower bound periods, where central banks have to resort to unconventional monetary policy since the short-term interest rate is close to zero, and cannot be lowered further. In recent years, a consensus has emerged regarding the effects of unconventional monetary policy on the term structure of interest rates (Wright 2012), Gürkaynak, Sack, and Swanson (2005a, 2005b, 2007); however, the overall effects on macroeconomic aggregates have been challenging to estimate, delivering sometimes estimates that are different from those expected from theory (Wu and Xia 2014).

Within the framework of this project, the researchers have illustrated how monetary policy considerably changed its behavior over time. On average, during the conventional period, monetary policy affected mostly the short end of the yield curve while leaving the long end unaffected; in the unconventional period, short-term interest rates were stuck at the zero lower bound, yet monetary policy successfully shifted the long end of the yield curve. Such changes are mainly explained by changes in the way monetary policy has affected both short- and long-term financial markets' expectations of interest rates and risk premia.

The major takeaway of the empirical analysis of this research project is that monetary policy shocks that unambiguously increase (or decrease) all yields have unambiguous contractionary (expansionary) effects on the economy. However, the macroeconomic responses to shocks that manifest themselves as increases in interest rates at some maturities and decreases at others are more complex: a shock that increases short-term interest rates, but decreases long-term ones, ends up decreasing output in the short-run while increasing it in the medium-run. An opposite shock, that decreases short-term rates while increasing long-term ones, has the opposite effect on output, increasing output in the short run while decreasing it in the medium run. This project has also shown that impulse responses associated with shocks that result in the same change in the yield at any given subset of maturities may still be very different from each other.

3. This project demonstrates that the traditional approach to the identification of monetary policy shocks may have either missed important shocks or was unable to differentiate between shocks that were very different from one another.

Cited References:

Gurkaynak, R.S., B. Sack and E. Swanson (2005a), Do Actions Speak Louder Than Words? The Response of Asset Prices to Monetary Policy Actions and Statements, International Journal of Central Banking 1(1),55-93.

Gurkaynak, R.S., B. Sack and E. Swanson (2005b), The Sensitivity of Long-Term Interest Rates to Economic News: Evidence and Implications for Macroeconomic Models, American Economic Review 95(1), 425-436.

Gurkaynak, R.S., B. Sack and E. Swanson (2007), Market-Based Measures of Monetary Policy Expectations, Journal of Business and Economic Statistics 25, 201-212.

Wright, J.H. (2012), What does Monetary Policy do to Long-term Interest Rates at the Zero Lower Bound?, Economic Journal 122, F447-F466.

Wu, C. and F.D. Xia (2014), Measuring the Macroeconomic Impact of Monetary Policy at the Zero Lower Bound, Journal of Money, Credit and Banking 48(2-3), 253-291.

Prizes and recognition

• Barbara Rossi was appointed an Econometric Society Fellow
• Advanced ERC grant application in process, following the research ideas from this project

Publications

Inoue, Atsushi and Barbara Rossi (2021). "The Effects of Conventional and Unconventional Monetary Policy: A New Approach." Quantitative Economics 12(4): 1085-1138

Dissemination

Conferences:

• ASSA
• International Association of Applied Econometrics
• NBER-NSF Time Series
• NBER summer institute 
• RBNZ

Keynote presentation: 

• Midwest Economic Group and the University of Sydney Workshop on Macroeconomics

Seminars: 

• DIW-Berlin
• Harvard University 
• University of Chicago 
• University of Missouri-Columbia
• University of Pennsylvania