Working Paper: CEPR ID: DP7827
Authors: Ana Beatriz C. Galvo; Massimiliano Marcellino
Abstract: This paper contributes to the literature on the changing transmission mechanism of monetary policy by introducing a model whose parameter evolution explicitly depends on the conduct of monetary policy. We find that the model fits the data well, in particular when complemented with an estimated break around 1985 that could be associated with the re-gained credibility of the central bank. The responses of output and inflation to policy shocks change not only because of the break in 1985 but also according to the monetary policy stance: policy shocks have stronger negative effects when policy is tight. There is also evidence in favour of large changes in the volatility of the output equation, but not of inflation. A set of counterfactual experiments indicate that good policy and good luck contributed to the "great moderation", but neither of them can fully explain it. A more general variation in the model dynamics underlying the shock transmission mechanism is required.
Keywords: Great Moderation; Impulse Responses; Monetary Policy; Time Varying Models
JEL Codes: C51; E52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Exogenous break in parameters at 1985 (C51) | Credibility of the central bank (E58) |
| Credibility of the central bank (E58) | Responses of output and inflation to monetary policy shocks (E31) |
| Monetary policy stance (tight) (E52) | Magnitude of shock's impact on output and inflation (E31) |
| Monetary policy regime (loose prior to 1985) (E65) | Volatility of output shocks (E39) |
| Good policy and good luck (M38) | Great Moderation (E65) |
| General change in model dynamics (C69) | Understanding of transmission of monetary shocks (E19) |