IDEAS home Printed from https://ideas.repec.org/p/ceu/econwp/2014_3.html
   My bibliography  Save this paper

Money, Banking and Interest Rates: Monetary Policy Regimes with Markov-Switching VECM Evidence

Author

Listed:
  • Max Gillman
  • Michal Kejak
  • Giulia Ghiani

Abstract

The paper sets out theory and evidence for the equilibrium determination of the nominal interest rate. We test the cash-in-advance economy using US postwar data and find cointegration of the interest rate, inflation, unemployment and the money supply, using either M2 or M1 monetary aggregates, and the Federal Funds rate or the three month Treasury bill rate. Results are consistent both with a persistent monetary liquidity effect in the cointegrating vector coefficients and also a long run quantity theoretic relation. We identify three Markov-switching regimes similar to NBER contractions, expansions, and the "unconventional" period. Dropping money indicates model misspecification.

Suggested Citation

  • Max Gillman & Michal Kejak & Giulia Ghiani, 2014. "Money, Banking and Interest Rates: Monetary Policy Regimes with Markov-Switching VECM Evidence," CEU Working Papers 2014_3, Department of Economics, Central European University.
  • Handle: RePEc:ceu:econwp:2014_3
    as

    Download full text from publisher

    File URL: http://www.personal.ceu.hu/staff/repec/pdf/2014_3.pdf
    File Function: Full text
    Download Restriction: no

    Other versions of this item:

    References listed on IDEAS

    as
    1. Ceri Davies & Max Gillman & Michal Kejak, 2012. "Deriving the Taylor Principle when the Central Bank Supplies Money," CEU Working Papers 2012_13, Department of Economics, Central European University, revised 23 Jul 2012.
    2. Berger, Allen N. & Humphrey, David B., 1997. "Efficiency of financial institutions: International survey and directions for future research," European Journal of Operational Research, Elsevier, vol. 98(2), pages 175-212, April.
    3. Peter N. Ireland, 2007. "Changes in the Federal Reserve's Inflation Target: Causes and Consequences," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 39(8), pages 1851-1882, December.
    4. MacKinnon, James G & Haug, Alfred A & Michelis, Leo, 1999. "Numerical Distribution Functions of Likelihood Ratio Tests for Cointegration," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 14(5), pages 563-577, Sept.-Oct.
    5. Assenmacher-Wesche, Katrin, 2006. "Estimating Central Banks' preferences from a time-varying empirical reaction function," European Economic Review, Elsevier, vol. 50(8), pages 1951-1974, November.
    6. M. D. Hayford & A. G. Malliaris, 2005. "How did the Fed react to the 1990s stock market bubble? Evidence from an extended Taylor rule," World Scientific Book Chapters,in: Economic Uncertainty, Instabilities And Asset Bubbles Selected Essays, chapter 14, pages 223-232 World Scientific Publishing Co. Pte. Ltd..
    7. Carmine Trecroci & Matilde Vassalli, 2010. "Monetary Policy Regime Shifts: New Evidence From Time‐Varying Interest Rate Rules," Economic Inquiry, Western Economic Association International, vol. 48(4), pages 933-950, October.
    8. Engle, Robert & Granger, Clive, 2015. "Co-integration and error correction: Representation, estimation, and testing," Applied Econometrics, Publishing House "SINERGIA PRESS", vol. 39(3), pages 106-135.
    9. Hansen, Bruce E, 1992. "The Likelihood Ratio Test under Nonstandard Conditions: Testing the Markov Switching Model of GNP," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 7(S), pages 61-82, Suppl. De.
    10. Benk, Szilárd & Gillman, Max & Kejak, Michal, 2010. "A banking explanation of the US velocity of money: 1919-2004," Journal of Economic Dynamics and Control, Elsevier, vol. 34(4), pages 765-779, April.
    11. Yash P. Mehra, 1997. "A review of the recent behavior of M2 demand," Economic Quarterly, Federal Reserve Bank of Richmond, issue Sum, pages 27-44.
    12. Cosmin L. Ilut & Martin Schneider, 2014. "Ambiguous Business Cycles," American Economic Review, American Economic Association, vol. 104(8), pages 2368-2399, August.
    13. Phillips, P.C.B., 1986. "Understanding spurious regressions in econometrics," Journal of Econometrics, Elsevier, vol. 33(3), pages 311-340, December.
    14. Leeper, Eric M. & Zha, Tao, 2003. "Modest policy interventions," Journal of Monetary Economics, Elsevier, vol. 50(8), pages 1673-1700, November.
    15. Christopher A. Sims & Tao Zha, 2006. "Were There Regime Switches in U.S. Monetary Policy?," American Economic Review, American Economic Association, vol. 96(1), pages 54-81, March.
    16. John B. Carlson & Jeffrey C. Schwarz, 1999. "Effects of movements in equities prices on M2 demand," Economic Review, Federal Reserve Bank of Cleveland, issue Q IV, pages 2-9.
    17. Lucio Sarno & Giorgio Valente & Mark E. Wohar, 2004. "Monetary Fundamentals and Exchange Rate Dynamics under Different Nominal Regimes," Economic Inquiry, Western Economic Association International, vol. 42(2), pages 179-193, April.
    18. Troy Davig & Eric M. Leeper, 2007. "Generalizing the Taylor Principle," American Economic Review, American Economic Association, vol. 97(3), pages 607-635, June.
    19. Peter C.B. Phillips & Shu-Ping Shi & Jun Yu, 2011. "Testing for Multiple Bubbles," Working Papers 09-2011, Singapore Management University, School of Economics.
    20. Perron, Pierre & Rodriguez, Gabriel, 2003. "GLS detrending, efficient unit root tests and structural change," Journal of Econometrics, Elsevier, vol. 115(1), pages 1-27, July.
    21. Szilárd Benk & Max Gillman & Michal Kejak, 2008. "Money Velocity in an Endogenous Growth Business Cycle with Credit Shocks," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 40(6), pages 1281-1293, September.
    22. Hansen, Bruce E, 1996. "Erratum: The Likelihood Ratio Test under Nonstandard Conditions: Testing the Markov Switching Model of GNP," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 11(2), pages 195-198, March-Apr.
    23. John H. Cochrane, 2011. "Determinacy and Identification with Taylor Rules," Journal of Political Economy, University of Chicago Press, vol. 119(3), pages 565-615.
    24. Frank Smets & Rafael Wouters, 2007. "Shocks and Frictions in US Business Cycles: A Bayesian DSGE Approach," American Economic Review, American Economic Association, vol. 97(3), pages 586-606, June.
    25. Efrem Castelnuovo & Luciano Greco & Davide Raggi, 2010. "Policy Rules, Regime Switches, and Trend Inflation: An Empirical Investigation for the U.S," "Marco Fanno" Working Papers 0109, Dipartimento di Scienze Economiche "Marco Fanno".
    26. Kristoffer P. Nimark, 2014. "Man-Bites-Dog Business Cycles," American Economic Review, American Economic Association, vol. 104(8), pages 2320-2367, August.
    27. Szilárd Benk & Max Gillman & Michal Kejak, 2005. "Credit Shocks in the Financial Deregulatory Era: Not the Usual Suspects," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 8(3), pages 668-687, July.
    28. Johansen, Soren, 1991. "Estimation and Hypothesis Testing of Cointegration Vectors in Gaussian Vector Autoregressive Models," Econometrica, Econometric Society, vol. 59(6), pages 1551-1580, November.
    29. Harding, Don & Pagan, Adrian, 2002. "Dissecting the cycle: a methodological investigation," Journal of Monetary Economics, Elsevier, vol. 49(2), pages 365-381, March.
    30. Giorgio Valente, 2003. "Monetary policy rules and regime shifts," Applied Financial Economics, Taylor & Francis Journals, vol. 13(7), pages 525-535.
    31. Hall, George J. & Sargent, Thomas J., 2014. "Fiscal discriminations in three wars," Journal of Monetary Economics, Elsevier, vol. 61(C), pages 148-166.
    32. Doornik, Jurgen A, 1998. " Approximations to the Asymptotic Distributions of Cointegration Tests," Journal of Economic Surveys, Wiley Blackwell, vol. 12(5), pages 573-593, December.
    33. Eric M. Leeper & Jennifer E. Roush, 2003. "Putting "M" back in monetary policy," Proceedings, Federal Reserve Bank of Cleveland, pages 1217-1264.
    34. Granger, C. W. J. & Newbold, P., 1974. "Spurious regressions in econometrics," Journal of Econometrics, Elsevier, vol. 2(2), pages 111-120, July.
    35. Barnett, William A & Offenbacher, Edward K & Spindt, Paul A, 1984. "The New Divisia Monetary Aggregates," Journal of Political Economy, University of Chicago Press, vol. 92(6), pages 1049-1085, December.
    36. John B. Taylor, 1999. "A Historical Analysis of Monetary Policy Rules," NBER Chapters,in: Monetary Policy Rules, pages 319-348 National Bureau of Economic Research, Inc.
    37. William T. Gavin & Benjamin D. Keen & Michael R. Pakko, 2005. "The monetary instrument matters," Review, Federal Reserve Bank of St. Louis, issue Sep, pages 633-658.
    38. Max Gillman & Michal Kejak & Michal Pakos, 2014. "Learning about Disaster Risk: Joint Implications for Consumption and Asset Prices," CERGE-EI Working Papers wp507, The Center for Economic Research and Graduate Education - Economics Institute, Prague.
    39. Johansen, Soren, 1988. "Statistical analysis of cointegration vectors," Journal of Economic Dynamics and Control, Elsevier, vol. 12(2-3), pages 231-254.
    40. Clark, Jeffrey A, 1984. "Estimation of Economies of Scale in Banking Using a Generalized Functional Form," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 16(1), pages 53-68, February.
    41. Salemi, Michael K., 2006. "Econometric Policy Evaluation and Inverse Control," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 38(7), pages 1737-1764, October.
    42. Saikkonen, Pentti, 1992. "Estimation and Testing of Cointegrated Systems by an Autoregressive Approximation," Econometric Theory, Cambridge University Press, vol. 8(01), pages 1-27, March.
    43. Gomme, Paul, 1993. "Money and growth revisited : Measuring the costs of inflation in an endogenous growth model," Journal of Monetary Economics, Elsevier, vol. 32(1), pages 51-77, August.
    44. Thornton, Daniel L., 2014. "Monetary policy: Why money matters (and interest rates don’t)," Journal of Macroeconomics, Elsevier, vol. 40(C), pages 202-213.
    45. Orphanides, Athanasios, 2003. "Historical monetary policy analysis and the Taylor rule," Journal of Monetary Economics, Elsevier, vol. 50(5), pages 983-1022, July.
    46. Hamilton, James D, 1989. "A New Approach to the Economic Analysis of Nonstationary Time Series and the Business Cycle," Econometrica, Econometric Society, vol. 57(2), pages 357-384, March.
    47. Stock, James H, 1987. "Asymptotic Properties of Least Squares Estimators of Cointegrating Vectors," Econometrica, Econometric Society, vol. 55(5), pages 1035-1056, September.
    48. Garcia, Rene, 1998. "Asymptotic Null Distribution of the Likelihood Ratio Test in Markov Switching Models," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 39(3), pages 763-788, August.
    49. Pär Osterholm, 2005. "The Taylor Rule: A Spurious Regression? ," Bulletin of Economic Research, Wiley Blackwell, vol. 57(3), pages 217-247, July.
    50. Andreas Schabert, "undated". "On the Equivalence of Money Growth and Interest Rate Policy," Working Papers 2003_6, Business School - Economics, University of Glasgow, revised Apr 2003.
    51. Bansal, Ravi & Coleman, Wilbur John, II, 1996. "A Monetary Explanation of the Equity Premium, Term Premium, and Risk-Free Rate Puzzles," Journal of Political Economy, University of Chicago Press, vol. 104(6), pages 1135-1171, December.
    52. Benati, Luca, 2009. "Long run evidence on money growth and inflation," Working Paper Series 1027, European Central Bank.
    53. Frank Smets & Raf Wouters, 2003. "An Estimated Dynamic Stochastic General Equilibrium Model of the Euro Area," Journal of the European Economic Association, MIT Press, vol. 1(5), pages 1123-1175, September.
    54. Perron, Pierre & Rodriguez, Gabriel, 2003. "GLS detrending, efficient unit root tests and structural change," Journal of Econometrics, Elsevier, vol. 115(1), pages 1-27, July.
    55. Gomme, Paul, 1993. "Money and growth revisited : Measuring the costs of inflation in an endogenous growth model," Journal of Monetary Economics, Elsevier, vol. 32(1), pages 51-77, August.
    56. Gillman, Max & Otto, Glen, 2006. "Money Demand in General Equilibrium Endogenous Growth: Estimating the Role of a Variable Interest Elasticity," Cardiff Economics Working Papers E2006/24, Cardiff University, Cardiff Business School, Economics Section, revised Oct 2006.
    57. Minford, Patrick & Perugini, Francesco & Srinivasan, Naveen, 2002. "Are interest rate regressions evidence for a Taylor rule?," Economics Letters, Elsevier, vol. 76(1), pages 145-150, June.
    58. Castelnuovo, Efrem & Greco, Luciano & Raggi, Davide, 2014. "Policy Rules, Regime Switches, And Trend Inflation: An Empirical Investigation For The United States," Macroeconomic Dynamics, Cambridge University Press, vol. 18(04), pages 920-942, June.
    59. Hansen, Peter Reinhard & Johansen, Soren, 1998. "Workbook on Cointegration," OUP Catalogue, Oxford University Press, number 9780198776079.
    Full references (including those not matched with items on IDEAS)

    More about this item

    JEL classification:

    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • E40 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - General
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

    NEP fields

    This paper has been announced in the following NEP Reports:

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:ceu:econwp:2014_3. See general information about how to correct material in RePEc.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Anita Apor). General contact details of provider: http://edirc.repec.org/data/deceuhu.html .

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service hosted by the Research Division of the Federal Reserve Bank of St. Louis . RePEc uses bibliographic data supplied by the respective publishers.