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A Model of Monetary Policy Shocks for Financial Crises and Normal Conditions

  • John Keating

    ()

    (University of Kansas, Department of Economics, Lawrence, KS 66045)

  • Logan Kelly

    ()

    (University of Wisconsin, Department of Economics, River Falls, WI 54022)

  • Andrew Lee Smith

    ()

    (University of Kansas, Department of Economics, Lawrence, KS 66045)

  • Victor J. Valcarcel

    ()

    (University of Wisconsin, Center for Economic Research, River Falls, WI 54022)

In their classic 1999 paper, "Monetary policy shocks: What have we learned and to what end?," Christiano, Eichenbaum, and Evans (CEE) investigate one of the most widely used methods for identifying monetary policy shocks of its time. Unfortunately, their approach is no longer viable, at least not in its original form. A major problem stems from the recent behavior of two key variables in their model, the Fed Funds rate and non-borrowed reserves. We develop a new identification scheme that remedies these difficulties but maintains the basic CEE framework. Our empirical specification is motivated by a standard New Keynesian DSGE model augmented by a simple financial structure. The model provides theoretical support for variables we use in place of certain variables that were used in the classic VAR approach outlined in CEE. One significant innovation is our use of Divisia M4, the broadest monetary aggregate currently available for the United States, as the policy indicator variable. We obtain four major empirical results that support the use of a properly measured broad monetary aggregate as the policy variable. First, policy shocks have significant effects on output and on the price level, even when an interest rate is included in our model -- contradicting the New-Keynesian argument that monetary aggregates are redundant. Second, we develop a model that is not subject to the output, price or liquidity puzzles common to this literature -- contradicting the view that using the interest rate as the policy indicator generally yields more reasonable responses than a monetary aggregate. Third, during normal conditions policy shocks from our Divisia-based model have similar effects on variables to those found in the Fed Funds model of monetary policy, and where there are differences our model with Divisia M4 obtains results that are more consistent with standard economic theory. Fourth, our preferred specification produces plausible responses to a monetary policy shock in samples that include or exclude the recent financial crisis.

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File URL: http://www2.uwrf.edu/RePEc/wrv/wpaper/cer1002.pdf
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Paper provided by UWRF - Center for Economic Research, College of Business and Economics, University of Wisconsin - River Falls in its series Working Papers in Economics and Finance with number 1002.

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Length: 68 pages
Date of creation: Mar 2014
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Handle: RePEc:wrv:wpaper:1002
Contact details of provider: Phone: 425-3991
Fax: 425-3536
Web page: http://www.uwrf.edu/cer
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