Nonlinearities, Smoothing and Countercyclical Monetary Policy

39 Pages Posted: 23 May 2016 Last revised: 3 Jan 2019

See all articles by Laura Jackson Young

Laura Jackson Young

Bentley University - Department of Economics

Michael Owyang

Federal Reserve Bank of St. Louis - Research Division

Daniel Soques

University of North Carolina (UNC) at Wilmington

Date Written: 2016-05-11

Abstract

Empirical analysis of the Fed’s monetary policy behavior suggests that the Fed smooths interest rates— that is, the Fed moves the federal funds rate target in several small steps instead of one large step with the same magnitude. We evaluate the effect of countercyclical policy by estimating a Vector Autoregression (VAR) with regime switching. Because the size of the policy shock is important in our model, we can evaluate the effect of smoothing the interest rate on the path of macro variables. Our model also allows for variation in transition probabilities across regimes, depending on the level of output growth. Thus, changes in the stance of monetary policy affect the macroeconomic variables in a nonlinear way, both directly and indirectly through the state of the economy. We also incorporate a factor summarizing overall sentiment into the VAR to determine if sentiment changes substantially around turning points and whether they are indeed important to understanding the effects of policy.

Keywords: Time-varying transition probabilities, Markov-switching, monetary policy

JEL Classification: C24, E32

Suggested Citation

Jackson Young, Laura and Owyang, Michael T. and Soques, Daniel, Nonlinearities, Smoothing and Countercyclical Monetary Policy (2016-05-11). FRB St. Louis Working Paper No. 2016-8, Available at SSRN: https://ssrn.com/abstract=2781868 or http://dx.doi.org/10.20955/wp.2016.008

Laura Jackson Young (Contact Author)

Bentley University - Department of Economics ( email )

175 Forest Street
Waltham, MA 02452-4705
United States

Michael T. Owyang

Federal Reserve Bank of St. Louis - Research Division ( email )

411 Locust St
Saint Louis, MO 63011
United States

Daniel Soques

University of North Carolina (UNC) at Wilmington ( email )

601 South College Road
Wilmington, NC 28403
United States

HOME PAGE: http://people.uncw.edu/soquesd/index.html

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