Modest Macroeconomic Effects of Monetary Policy Shocks during the Great Moderation: An Alternative Interpretation

Melbourne Institute Working Paper No. 30/16

Date: 2016


Efrem Castelnuovo


Cholesky-VAR impulse responses estimated with post-1984 U.S. data predict modest macroeconomic reactions to monetary policy shocks. We interpret this evidence by employing an estimated medium-scale DSGE model of the business cycle as a Data-Generating Process in a Monte Carlo exercise in which a Cholesky-VAR econometrician is asked to estimate the effects of an unexpected, temporary increase in the policy rate. Our structural DSGE model predicts conventional macroeconomic reactions to a policy shock. In contrast, our Monte Carlo VAR results replicate our evidence obtained with actual U.S. data. Hence, modest macroeconomic effects may very well be an artifact of Cholesky-VARs. A combination of supply and demand shocks may be behind the inability of Cholesky-VARs to replicate the actual macroeconomic responses. The difference in the VAR responses obtained with Great Inflation vs. Great Moderation data may be due to instabilities in the parameters related to households’ and firms’ programs, more than to a more aggressive systematic monetary policy. A Monte Carlo assessment of sign restrictions as an alternative identification strategy is also proposed.

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  • Monetary policy shocks, Cholesky identification, VARs, Dynamic Stochastic General Equilibrium models, Monte Carlo simulations