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Monetary policy in a Markov-switching VECM: implications for the cost of disinflation and the price puzzle

  • Neville Francis
  • Michael T. Owyang

Monetary policy VARs typically presume stability of the long-run outcomes. We introduce the possibility of switches in the long-run equilibrium in a cointegrated VAR by allowing both the covariance matrix and weighting matrix in the error-correction term to switch. We find that monetary policy alternates between sustaining long-run growth and disinflationary regimes. Allowing state changes can also help explain the price puzzle and justify the use of commodity prices as a corrective measure. Finally, we show that regime-switching has implications for disinflationary monetary policy and can explain the variety of sacrifice ratio estimates that exist in the literature.

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Paper provided by Federal Reserve Bank of St. Louis in its series Working Papers with number 2003-001.

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Date of creation: 2004
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Publication status: Published in Journal of Business and Economic Statistics, July 2005, 23(3), pp. 305-13
Handle: RePEc:fip:fedlwp:2003-001
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  1. Lawrence J. Christiano & Martin Eichenbaum & Charles L. Evans, 1998. "Monetary Policy Shocks: What Have We Learned and to What End?," NBER Working Papers 6400, National Bureau of Economic Research, Inc.
  2. Faust, Jon & Svensson, Lars E O, 1998. "Transparency and Credibility: Monetary Policy with Unobservable Goals," CEPR Discussion Papers 1852, C.E.P.R. Discussion Papers.
  3. Christopher A. Sims & Tao Zha, 1999. "Error Bands for Impulse Responses," Econometrica, Econometric Society, vol. 67(5), pages 1113-1156, September.
  4. Paap, R. & van Dijk, H.K., 2002. "Bayes estimates of Markov trends in possibly cointegrated series: an application to US consumption and income," Econometric Institute Research Papers EI 2002-42, Erasmus University Rotterdam, Erasmus School of Economics (ESE), Econometric Institute.
  5. Hanson, Michael S., 2006. "Varying monetary policy regimes: A vector autoregressive investigation," Journal of Economics and Business, Elsevier, vol. 58(5-6), pages 407-427.
  6. Michael Owyang & Garey Ramey, 2003. "Regime switching and monetary policy measurement," Working Papers 2001-002, Federal Reserve Bank of St. Louis.
  7. Galí, Jordi, 1996. "Technology, Employment, and the Business Cycle: Do Technology Shocks Explain Aggregate Fluctuations?," CEPR Discussion Papers 1499, C.E.P.R. Discussion Papers.
  8. Jeffrey C. Fuhrer, 1995. "The persistence of inflation and the cost of disinflation," New England Economic Review, Federal Reserve Bank of Boston, issue Jan, pages 3-16.
  9. Christopher A. Sims, 1992. "Interpreting the Macroeconomic Time Series Facts: The Effects of Monetary Policy," Cowles Foundation Discussion Papers 1011, Cowles Foundation for Research in Economics, Yale University.
  10. Richard Dennis, 2006. "The policy preferences of the US Federal Reserve," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 21(1), pages 55-77.
  11. Leeper, Eric M. & Gordon, David B., 1992. "In search of the liquidity effect," Journal of Monetary Economics, Elsevier, vol. 29(3), pages 341-369, June.
  12. Christopher A. Sims, 1986. "Are forecasting models usable for policy analysis?," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 2-16.
  13. Jean Boivin & Marc Giannoni, 2002. "Has monetary policy become less powerful?," Staff Reports 144, Federal Reserve Bank of New York.
  14. John B. Taylor, 1999. "Monetary Policy Rules," NBER Books, National Bureau of Economic Research, Inc, number tayl99-1, November.
  15. 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 357-84, March.
  16. Olivier Jean Blanchard & Danny Quah, 1988. "The Dynamic Effects of Aggregate Demand and Supply Disturbances," NBER Working Papers 2737, National Bureau of Economic Research, Inc.
  17. Cecchetti, Stephen G & Rich, Robert W, 2001. "Structural Estimates of the U.S. Sacrifice Ratio," Journal of Business & Economic Statistics, American Statistical Association, vol. 19(4), pages 416-27, October.
  18. John Geweke, 1991. "Evaluating the accuracy of sampling-based approaches to the calculation of posterior moments," Staff Report 148, Federal Reserve Bank of Minneapolis.
  19. Christopher A. Sims & Tao A. Zha, 1998. "Does monetary policy generate recessions?," Working Paper 98-12, Federal Reserve Bank of Atlanta.
  20. repec:cup:etheor:v:10:y:1994:i:3-4:p:645-71 is not listed on IDEAS
  21. Chang-Jin Kim & Charles R. Nelson, 1999. "State-Space Models with Regime Switching: Classical and Gibbs-Sampling Approaches with Applications," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262112388, June.
  22. Andrew J. Filardo, 1998. "New evidence on the output cost of fighting inflation," Economic Review, Federal Reserve Bank of Kansas City, issue Q III.
  23. Allan w. Gregory & Bruce E. Hansen, 1992. "residual-Based Tests for Cointegration in Models with Regime Shifts," Working Papers 862, Queen's University, Department of Economics.
  24. Richard Clarida & Jordi Galí & Mark Gertler, 2000. "Monetary Policy Rules And Macroeconomic Stability: Evidence And Some Theory," The Quarterly Journal of Economics, MIT Press, vol. 115(1), pages 147-180, February.
  25. Okun, Arthur M, 1978. "Efficient Disinflationary Policies," American Economic Review, American Economic Association, vol. 68(2), pages 348-52, May.
  26. Hall, Stephen G & Psaradakis, Zacharias & Sola, Martin, 1997. "Cointegration and Changes in Regime: The Japanese Consumption Function," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 12(2), pages 151-68, March-Apr.
  27. Eric M. Leeper & Christopher A. Sims & Tao Zha, 1996. "What Does Monetary Policy Do?," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 27(2), pages 1-78.
  28. repec:dgr:uvatin:19990024 is not listed on IDEAS
  29. Ben S. Bernanke & Ilian Mihov, 1995. "Measuring Monetary Policy," NBER Working Papers 5145, National Bureau of Economic Research, Inc.
  30. Michael T. Owyang, 2002. "Modeling Volcker as a non-absorbing state: agnostic identification of a Markov-switching VAR," Working Papers 2002-018, Federal Reserve Bank of St. Louis.
  31. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
  32. Hamilton, James D., 1990. "Analysis of time series subject to changes in regime," Journal of Econometrics, Elsevier, vol. 45(1-2), pages 39-70.
  33. Christopher Sims & Tao Zha, 2002. "Macroeconomic switching," Proceedings, Federal Reserve Bank of San Francisco, issue Mar.
  34. Jeffrey C. Fuhrer, 1994. "Optimal monetary policy and the sacrifice ratio," Conference Series ; [Proceedings], Federal Reserve Bank of Boston, vol. 38, pages 43-84.
  35. Uhlig, Harald, 1994. "What Macroeconomists Should Know about Unit Roots: A Bayesian Perspective," Econometric Theory, Cambridge University Press, vol. 10(3-4), pages 645-671, August.
  36. Hanson, Michael S., 2004. "The "price puzzle" reconsidered," Journal of Monetary Economics, Elsevier, vol. 51(7), pages 1385-1413, October.
  37. Engle, Robert F & Granger, Clive W J, 1987. "Co-integration and Error Correction: Representation, Estimation, and Testing," Econometrica, Econometric Society, vol. 55(2), pages 251-76, March.
  38. Neville Francis & Valerie A. Ramey, 2002. "Is the Technology-Driven Real Business Cycle Hypothesis Dead?," NBER Working Papers 8726, National Bureau of Economic Research, Inc.
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