October 01, 2003

Industrial Production is Often and Substantially a Monetary Phenomenon

Christina Romer and David Romer have a new measure of monetary policy "shocks"--of shifts in monetary policy that are not responses to expected economic developments. Such a measure is important because without it you cannot untangle (a) the effects of monetary policy from (b) events that were forecast and were thus not consequences but causes (in an expectational, time-reversed sense) of monetary policy.

There measure leads to the conclusion that in America today monetary policy is really powerful: "The cumulative response of industrial production to our measure of monetary shocks indicates a strong relationship. Industrial production begins to fall five months after [an increase in interest rates] and reaches its minimum after 22 months. The effects of monetary shocks on real output are both large and statistically significant. A [one percentage]-point shock to the funds rate is associated with a reduction in industrial production of 4.8% after 22 months."

A New Measure of Monetary Shocks: Derivation and Implications: Conventional measures of monetary policy, such as the federal funds rate, are surely influenced by forces other than monetary policy. More importantly, central banks adjust policy in response to a wide range of information about future economic developments. As a result, estimates of the effects of monetary policy derived using conventional measures will tend to be biased. To address this problem, we develop a new measure of monetary policy shocks in the United States for the period 1969 to 1996 that is relatively free of endogenous and anticipatory movements. The derivation of the new measure has two key elements. First, to address the problem of forward-looking behavior, we control for the Federal Reserve's forecasts of output and inflation prepared for scheduled FOMC meetings. We remove from our measure policy actions that are a systematic response to the Federal Reserve's anticipations of future developments. Second, to address the problem of endogeneity and to ensure that the forecasts capture the main information the Federal Reserve had at the times decisions were made, we consider only changes in the Federal Reserve's intentions for the federal funds rate around scheduled FOMC meetings. This series on intended changes is derived using information on the expected funds rate from the records of the Open Market Manager and information on intentions from the narrative records of FOMC meetings. The series covers the entire period for which forecasts are available, including times when the Federal Reserve was not exclusively targeting the funds rate. Estimates of the effects of monetary policy obtained using the new measure indicate that policy has large, relatively rapid, and statistically significant effects on both output and inflation. We find that the effects using the new measure are substantially stronger and quicker than those using prior measures. This suggests that previous measures of policy shocks are significantly contaminated by forward-looking Federal Reserve behavior and endogeneity.

Posted by DeLong at October 1, 2003 08:22 PM | TrackBack

Comments

That seems to be a complex way of saying that Monetarism is a driving force (a priori) of actual end user demand.

Its not such a leap to suggest such a large impact, as Monetary policy affects the ultimate cost of goods and services, and therefor impacts end demand.

And by shock, I assume you mean increase (and not 1% decrease). Again all that suggests is that the cost of money matters to producers.

Posted by: Barry Ritholtz on October 2, 2003 04:00 AM

I haven't read the paper, and so I don't know if the following assumption is borne out by the paper's results: suppose that the response of IP to monetary shocks is symmetric for both positive and negative shocks. If that is the case, then the US economy has already had all of the benefit from nearly all of the Fed's interest rate cuts. Nearly all of the cuts happened prior to Dec 2001 -- 22 months ago. There have only been two cuts since then; a half-point cut 11 months ago, and a quarter point cut 4 months ago. My conclusion is that US has already seen nearly all of the bang that monetary policy can give us.

Posted by: Kash on October 2, 2003 04:52 AM

Yep. According to Romer and Romer, there's very little additional monetary stimulus still in the pipeline...

Posted by: Brad DeLong on October 2, 2003 06:30 AM
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