News Shocks and the Effects of Monetary Policy

Abstract

Traditionally identified monetary shocks in a structural vector autoregression (SVAR) model typically result in long-lasting effects on output and total factor productivity (TFP). In this paper, I argue that the typical monetary shock has been confounded with the news shock about future technology. I propose and implement a novel SVAR approach that effectively ``cleans'' the technology component from the traditional Cholesky monetary shock. With the new identification, I find that a monetary shock exerts smaller and less persistent effects on output and the level of measured TFP than a traditionally identified monetary shock. The new identification also predicts a ``Fisherian'' effect that an unanticipated rise in the interest rate increases inflation. The novel empirical findings can reconcile some conflicting results in the SVAR literature and hence lead to a better understanding of the effects of monetary policy. Finally, I show that the standard New Keynesian model is not fully consistent with the empirical evidence uncovered by the novel SVAR method. However, the SVAR impulse responses can be replicated by augmenting the standard New Keynesian model with a time-varying inflation target and a non-Ricardian fiscal policy regime.

Keywords: monetary policy, news shock, VAR model, DSGE, fiscal theory of price level

JEL Classification: E32, E52