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The monetary policy innovation paradox in VARs: a "discrete" explanation

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Listed author(s):
  • Michael J. Dueker

Abstract

Monetary policy shocks derived from VARs often suggest that monetary policymakers regularly react to an unexpected increase that they induced in the federal funds rate with additional increases. This puzzling pattern can be called the “policy innovation paradox” because there is no obvious explanation for such a pattern. This article shows that the policy innovation paradox is most likely an artifact of failing to account for the discreteness of changes that policymakers make to the target federal funds rate. Mis-specified VARs that fail to account for discrete target changes imply the policy innovation paradox, whereas a model that uses information from discrete policy changes does not.

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File URL: https://files.stlouisfed.org/files/htdocs/publications/review/02/03/43-50Dueker.pdf
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Article provided by Federal Reserve Bank of St. Louis in its journal Review.

Volume (Year): (2002)
Issue (Month): Mar. ()
Pages: 43-50

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Handle: RePEc:fip:fedlrv:y:2002:i:mar.:p:43-50:n:v.84no.2
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Keywords: Monetary policy ; Federal funds rate ; Vector autoregression;

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  1. Christiano, Lawrence J. & Eichenbaum, Martin & Evans, Charles L., 1999. "Monetary policy shocks: What have we learned and to what end?," Handbook of Macroeconomics,in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 2, pages 65-148 Elsevier.
  2. Croushore, Dean & Evans, Charles L., 2006. "Data revisions and the identification of monetary policy shocks," Journal of Monetary Economics, Elsevier, vol. 53(6), pages 1135-1160, September.
  3. Sims, Christopher A, 1980. "Macroeconomics and Reality," Econometrica, Econometric Society, vol. 48(1), pages 1-48, January.
  4. Rudebusch, Glenn D., 1995. "Federal Reserve interest rate targeting, rational expectations, and the term structure," Journal of Monetary Economics, Elsevier, vol. 35(2), pages 245-274, April.
  5. John B. Taylor, 1999. "Monetary Policy Rules," NBER Books, National Bureau of Economic Research, Inc, number tayl99-1.
  6. James H. Stock & Mark W. Watson, 2001. "Vector Autoregressions," Journal of Economic Perspectives, American Economic Association, vol. 15(4), pages 101-115, Fall.
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Cited by:

  1. Brissimis, Sophocles N. & Magginas, Nicholas S., 2006. "Forward-looking information in VAR models and the price puzzle," Journal of Monetary Economics, Elsevier, vol. 53(6), pages 1225-1234, September.
  2. Anatoliy Belaygorod & Michael J. Dueker, 2005. "Discrete monetary policy changes and changing inflation targets in estimated dynamic stochastic general equilibrium models," Review, Federal Reserve Bank of St. Louis, issue Nov, pages 719-734.
  3. Michael J. Dueker & Robert H. Rasche, 2004. "Discrete policy changes and empirical models of the federal funds rate," Review, Federal Reserve Bank of St. Louis, issue Nov, pages 61-72.
  4. Siddhartha Chib & Michael Dueker & Anatoliy Belaygorod, 2005. "Structural Breaks in Estimated DSGE Models with Indeterminacy," Computing in Economics and Finance 2005 357, Society for Computational Economics.

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