Assessing Changes in the Monetary Transmission Mechanism: A VAR Approach

1. INTRODUCTION Several authors have documented a reduced variability of output and inflation in the United States since the beginning of the 1980s. (1) In fact, a comparison of the 1980:1-2001:2 period with the two preceding decades shows that the standard deviation of quarterly output growth has fallen 30 percent, while the standard deviation of inflation has decreased more than 40 percent. These changes in the time series properties of output and inflation raise a number of important questions for policymakers. For instance, has this increased stability been associated with an alteration of the transmission of monetary policy due, for example, to changes in the behavior of consumers, firms, or the Federal Reserve? Does monetary policy still affect inflation and output as much as it did in the 1960s and 1970s? Should we expect the reduced volatility of the U.S. economy to last? The answers to these questions depend in fact on the origin of the changes. In particular, they require a determination of whether the reduced volatility of output and inflation is due to smaller and less frequent disturbances, such as shocks to productivity, foreign economies, fiscal policy, and monetary policy, or whether the propagation of these shocks has changed so that output and inflation have become less sensitive to shocks. Clearly, if the main cause of the increased economic stability in the past two decades is a reduction in the importance of exogenous shocks, or special circumstances, then there is a good chance that once confronted again with large successive shocks, the economy will again become more volatile. Alternatively, if most of the reduced volatility is due to a change in the propagation of the disturbances, then it is plausible to expect the greater stability to last. In the latter case, it is also plausible to think that the monetary transmission mechanism has changed. Several factors may have rendered the economy more immune to shocks. On the one hand, firms and consumers may have changed their behavior and the organization of markets in a way that has reduced the effect of given shocks on output and inflation. For instance, Kahn, McConnell, and Perez-Quiros (2002) argue that a more effective management of inventories has been an important factor behind the reduction in the variability in output. On the other hand, the conduct of monetary policy may have been more responsive to fluctuations in inflation and output since the beginning of the 1980s, partly compensating for the effect that shocks may have had on inflation and output (see Clarida, Gali, and Gertler [2000] and Boivin and Giannoni [2002]). In this paper, we seek to understand more clearly the nature of the changes in the U.S. economy over the past four decades, and to determine whether the reduction in output and inflation variability has been associated with a change in the transmission of monetary policy. First, we estimate a small vector autoregression (VAR) model using U.S. data from 1960 to 2001 and test for its stability. Our results suggest that instability is prevalent both in the systematic part of the estimated VAR and in the variance of shocks. Second, through counterfactual experiments, we assess whether the reduced variability of the economy is due principally to less important shocks (or special events) or to changes in the propagation mechanism of these shocks. We find that the change in the propagation of the shocks in the past two decades accounts for roughly 40 percent of the decrease in the variance of detrended output and for 60 percent of the reduction in the variance of inflation. Because we find that a significant fraction of the reduced volatility is attributable to a change in the propagation of the shocks, we impose more structure on our empirical model to assess whether there has been a change in the transmission of monetary policy. We find that output and inflation have displayed diminished dynamic responses to unexpected federal funds rate movements since the beginning of the 1980s. …