Has Monetary Policy Become More Effective?

Abstract

Recent research provides evidence of important changes in the U.S. economic environment over the last 40 years. This appears to be associated with an alteration of the monetary transmission mechanism. In this paper we investigate the implications for the evolution of monetary policy effectiveness. Using an identified VAR over the pre- and post-1980 periods we first provide evidence of a reduction in the effect of monetary policy shocks in the latter period. We then present and estimate a fully specified model that replicates well the dynamic response of output, inflation, and the federal funds rate to monetary policy shocks in both periods. Using the estimated structural model, we perform counterfactual experiments to determine the source of the observed change in the monetary transmission mechanism, as well as in the economy's response to supply and demand shocks. The main finding is that monetary policy has been more stabilizing in the recent past, as a result of both the way it has responded to shocks, but also by ruling out non-fundamental fluctuations.