Working Paper: CEPR ID: DP7096
Authors: Ruslan Bikbov; Mikhail Chernov
Abstract: This paper proposes to investigate whether US monetary policy changed over time by evaluating evidence from the entire yield curve. A regime-switching no-arbitrage term structure model relies on inflation, output and the short interest rate as factors. In a departure from the finance literature, the model is complemented with identifying assumptions that allow the private sector (inflation and output dynamics) to be separated from monetary policy (short interest rate). The model posits regime changes in the volatility of exogenous output and inflation shocks, in the monetary policy rule, and in the volatility of monetary shocks. The monetary policy regimes cannot be identified correctly if the yield curve is ignored during estimation. Counterfactual analysis uses the disentangled regimes in policy and shocks to understand their importance for the great moderation. The low-volatility regime of exogenous shocks during the last two decades plays an important role, while monetary policy contributes by trading off asymmetric responses of output and inflation under different regimes.
Keywords: Great Moderation; Monetary Policy; Regime Switches; Structural VAR; Term Structure Model
JEL Codes: C52; E43
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| US monetary policy switching between active and passive regimes (E63) | Federal Reserve's response to expected inflation (E31) |
| Active regime (E63) | Strong reaction coefficient to inflation (E31) |
| Passive regime (E63) | Weaker response of interest rate to expected inflation (E49) |
| Yield curve (E43) | Information about expected future interest rates (E43) |
| Yield curve (E43) | Reduces bias of estimated monetary policy regimes (C54) |
| Transition from high to low volatility of exogenous shocks (E32) | Contribution to the Great Moderation (E39) |
| Monetary policy (E52) | Managing trade-offs between output and inflation across different regimes (E63) |