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Regime switching in the dynamic relationship between the federal funds rate and innovations in nonborrowed reserves

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  • Chan Huh
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    Abstract

    This paper examines the dynamic relationship between changes in the funds rate and nonborrowed reserves within a reduced form framework that allows the relationship to have two distinct patterns over time. A regime switching model a la Hamilton (1989) is estimated. On average, CPI inflation has been significantly higher in the regime characterized by large and volatile changes in funds rate. Innovations in money growth are associated with a strong anticipated inflation effect in this high inflation regime, and a moderate liquidity effect in the low inflation regime. Furthermore, an identical money innovation generates a much bigger increase in the interest rate during a transition period from the low to high inflation regime than during a steady high inflation period. This accords well with economic intuition since the transition period is when the anticipated inflation effect initially gets incorporated into the interest rate. The converse also holds. That is, the liquidity effect becomes stronger when the economy leaves a high inflation regime period and enters a low inflation regime period.

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    File URL: http://www.federalreserve.gov/pubs/ifdp/1996/536/default.htm
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    File URL: http://www.federalreserve.gov/pubs/ifdp/1996/536/ifdp536.pdf
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    Bibliographic Info

    Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series International Finance Discussion Papers with number 536.

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    Date of creation: 1996
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    Handle: RePEc:fip:fedgif:536

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    Keywords: Bank reserves ; Federal funds market (United States);

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    1. Reichenstein, William, 1987. "The Impact of Money on Short-term Interest Rates," Economic Inquiry, Western Economic Association International, vol. 25(1), pages 67-82, January.
    2. Steven Strongin, 1992. "The identification of monetary policy disturbances: explaining the liquidity puzzle," Working Paper Series, Macroeconomic Issues 92-27, Federal Reserve Bank of Chicago.
    3. Eric M. Leeper & David B. Gordon, 1991. "In search of the liquidity effect," Working Paper 91-17, Federal Reserve Bank of Atlanta.
    4. René Garcia, 1995. "Asymptotic Null Distribution of the Likelihood Ratio Test in Markov Switching Models," CIRANO Working Papers 95s-07, CIRANO.
    5. Michael D. Boldin, 1992. "Using switching models to study business cycle asymmetries: 1. overview of methodology and application," Research Paper 9211, Federal Reserve Bank of New York.
    6. Adrian R. Pagan & John C. Robertson, 1995. "Resolving the liquidity effect," Review, Federal Reserve Bank of St. Louis, issue May, pages 33-54.
    7. Daniel L. Thornton, 1988. "The effect of monetary policy on short-term interest rates," Review, Federal Reserve Bank of St. Louis, issue May, pages 53-72.
    8. Hansen, B.E., 1991. "Inference when a Nuisance Parameter is Not Identified Under the Null Hypothesis," RCER Working Papers 296, University of Rochester - Center for Economic Research (RCER).
    9. Chan Huh, 1995. "Regime switching in the dynamic relationship between the federal funds rate and nonborrowed reserves," Working Papers in Applied Economic Theory 95-11, Federal Reserve Bank of San Francisco.
    10. Coleman, Wilbur John, II & Gilles, Christian & Labadie, Pamela A, 1996. "A Model of the Federal Funds Market," Economic Theory, Springer, vol. 7(2), pages 337-57, February.
    11. Fuerst, Timothy S., 1992. "Liquidity, loanable funds, and real activity," Journal of Monetary Economics, Elsevier, vol. 29(1), pages 3-24, February.
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