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Identifying a Forward-Looking Monetary Policy in an Open Economy

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  • Rokon Bhuiyan

    () (QED)

Abstract

I identify a forward-looking monetary policy function in a structural VAR model by using forecasts of macroeconomic variables, in addition to the realized variables used in a standard VAR. Both impulse responses and variance decompositions of the monetary policy variable of this forecast-augmented VAR model suggest that forecasted variables play a greater role than realized variables in a central bank’s policy decisions. I also find that a contractionary policy shock instantaneously increases the market interest rate as well as the forecast of the market interest rate. The policy shock also appreciates both the British pound and the forecast of the pound on impact. On the other hand, the policy shock lowers expected inflation immediately, but affects realized inflation with a lag. When I estimate the standard VAR model encompassed in the forecast-augmented model, I find that a contractionary policy shock raises the inflation rate and leads to a gradual appreciation of the domestic currency. However, the inclusion of inflation expectations reverses this puzzling response of the inflation rate, and the inclusion of both the market interest rate forecast and the exchange rate forecast removes the delayed overshooting response of the exchange rate. These findings suggest that a standard VAR may incorrectly identify the monetary policy function.

Suggested Citation

  • Rokon Bhuiyan, 2009. "Identifying a Forward-Looking Monetary Policy in an Open Economy," Working Papers 1214, Queen's University, Department of Economics.
  • Handle: RePEc:qed:wpaper:1214
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    File URL: http://qed.econ.queensu.ca/working_papers/papers/qed_wp_1214.pdf
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    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
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • F37 - International Economics - - International Finance - - - International Finance Forecasting and Simulation: Models and Applications

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