Federal reserve policy viewed through a money supply lens

Abstract

This paper examines whether the U.S. Federal Reserve has adjusted high-powered money supply in response to macroeconomic indicators. Applying ex-post and real-time data for the postwar period, we provide evidence that nonborrowed reserves responded to expected in ‡ation and the output-gap. While the output-gap feedback has always been negative, the response of money supply to changes in in ‡ation varies considerably across time. The in ‡ation feedback is negative in the post-1979 period and positive, albeit smaller than one, in the pre-1979 period. Applying a standard macroeconomic model, these properties are shown to be consistent with a welfare maximizing policy, and to ensure equilibrium determinacy. Viewed through the money supply lens, the Fed has thus never allowed for endogenous ‡uctuations, which contrasts conclusions drawn from federal funds rate analyses.

Stock vs. Bond yields and demographic fluctuations

“…The results presented in Table A.1 show that, over the entire period and the pre-crisis period, money supply did not significantly react to inflation, a result which is in line with the existing literature (Chowdhury and Schabert, 2008;Sargent and Surico, 2011) and with the history of the FED's monetary policy strategy (Meulendyke, 1998). We also split the sample into two sub-periods: the pre-Volker period (1961Q1-1979Q2) and the post-Volker period (1982Q4-2013Q1).…”

“…as introduced by Chowdhury and Schabert (2008). µ t represents the growth rate of nonborrowed reserves, E t π t+n the expected inflation rate in t + n, y t the real output, and y * t the time-varying potential output.…”

Dissecting Taylor Rules in a Structural VAR

“…Specifically, they examine the effect of a shock on the economy when the endogenous policy response is "shut off"-that is, when the funds rate is held fixed for the initial four quarters, after which its behavior is governed by historical policy rule. 17 They find that the effects of an oil price shock on output are reduced considerably when the endogenous response 16 Our finding is consistent with Chowdhury and Schabert's (2008) finding from the "money supply lens" approach-which looks at that money supply responses to inflation and the output gap-that the Fed policy was sufficiently reactive to inflation so as to ensure equilibrium determinacy during the pre-1979 period.…”

Liquidity traps and large-scale financial crises

“…Given the Cholesky structure of our structural TVAR, this ordering, at least as far as the contemporaneous response of money is concerned, is consistent with the money growth rule à la McCallum (1990), which does not feature the nominal interest rate as variables liquidity responds to. Empirical evidence provided by Damette and Parent (2016a) for the Great Depression and by Chowdhury and Schabert (2008) for the post-WWII era o¤ers support to this assumption. This triangular structure of the economy is also consistent with a money demand equation featuring the nominal interest rate as one of its drivers in the form of opportunity cost.…”

“…Hence, the ordering of the variables in our VAR is important for the identi…cation of the liquidity shock. We order money supply after the price and quantity macroeconomic indicators to be consistent with the view of a money supply rule systematically moving the stock of nominal money in a contemporaneous fashion, as in Chowdhury and Schabert (2008). Di¤erently, we do not allow for a systematic response of money to an interest rate shock in order to sharpen the identi…cation of money supply shocks (those we aim at identifying in this paper to test for the presence of a KLT) as opposed to money demand shocks (which would call for the control of contemporaneous interest rates consistently with a standard money demand schedule).…”