Paper for a conference sponsored by the Federal Reserve Bank of New York entitled Financial Innovation and Monetary TransmissionEconomic conditions - United States ; Monetary policy

Mark W. Watson

English

Research Papers in Economics

FRBNY Economic Policy Review / May 2002 113
n their paper, Jean Boivin and Marc Giannoni ask whether
 the monetary transmission mechanism has changed. More 
precisely, they ask whether the macroeconomic effects of 
monetary policy shocks in the United States were different in 
the 1980s and 1990s relative to the 1960s and 1970s. The 
authors conclude that these effects have changed and that the 
primary cause of this change has been a shift in monetary 
policy. They carry out their empirical analysis using reduced-
form and structural vector autoregressions (VARs). In a 
companion paper, Boivin and Giannoni (2002) address the 
same question using a small-scale structural model, and arrive 
at the same general conclusion.
Their paper in this volume begins by carefully documenting 
the instability in a typical VAR estimated using quarterly macro 
data for the United States over 1963-97. They examine 
instability from two potential sources: the VAR coefficients and 
the covariance matrix of the VAR errors. They find instability 
from both sources. As the authors note, these results are 
consistent with a large and growing body of empirical evidence 
on instability in macroeconomic relations.
The paper then investigates two distinct but related 
questions. First, several researchers (see, for example, 
McConnell and Perez-Quiros [2000]) have documented a 
substantial decrease in the variability of real macroeconomic 
activity (for instance, GDP growth rates) and inflation in the 
1980s and 1990s relative to the 1960s and 1970s. Boivin and 
Giannoni ask whether this decrease in variability is associated 
with changes in the reduced-form VAR coefficients or with 
changes in the VAR error covariance matrix. They conclude 
that both are important. Second, using a structural VAR, the 
authors document changes in the impulse response function 
of output and inflation to monetary policy shocks. They ask 
whether these changes are associated with changes in the 
coefficients of the interest rate equation (the structural VAR’s 
monetary policy rule) or with the coefficients in the other 
equations. They conclude that changes in the monetary policy 
rule are responsible for the change in the impulse responses.
I will now discuss both questions. 
The Relative Stability 
of the Macroeconomy
Boivin and Giannoni’s Table 3 summarizes the study’s con-
clusion about this question. It presents the implied variability 
of output and inflation computed from a reduced-form VAR 
with coefficients A and covariance matrix  . In the 1963-79 
sample period, output and inflation are much more variable 
than in the 1980-97 sample period. Can this change in 
variability be accounted for by a change in A, a change in  , 
or are changes in both needed? The authors conclude that 
changes in both A and   are necessary, and their rationale is 
Σ u
Σ u
Σ u
Mark W. Watson
The views expressed are those of the author and do not necessarily reflect the 
position of the Federal Reserve Bank of New York or the Federal Reserve 
System.
Commentary
Mark W. Watson is a professor of economics and public affairs at Princeton 
University’s Woodrow Wilson School.
I114 Commentary
evident in the top panel of Table 3. However, the bottom panel 
tells a somewhat different story: comparing the 1963-78 and 
1984-97 sample periods, it shows that nearly all of the fall in the 
variability of output is associated with a change in  , although 
changes in A and   are needed to explain the fall in the 
variability of inflation.
Several authors (see, for example, McConnell and Perez-
Quiros [2000], Chauvet and Potter [2001], and Kim, Nelson, 
and Piger [2001]) estimate a break in the variability of GDP 
around the first quarter of 1984. Using this break date, it seems 
fair to conclude from the authors’ Table 3 that nearly all of the 
change in output variability is associated with changes in the 
reduced-form VAR error covariance matrix. This is the 
conclusion reached in several other recent papers (Ahmed, 
Levin, and Wilson 2001; Simon 2000; Stock and Watson 2002). 
For example, the table below shows the standard deviation of 
four-quarter changes in the logarithm of GDP and GDP 
inflation from a VAR like the one used by Boivin and Giannoni 
for two samples: 1960-83 and 1984-2001. It presents results like 
those in the bottom panel of Boivin and Giannoni’s Table 3. 
That is, nearly all of the change in the variability in GDP growth 
is associated with a change in the error covariance matrix.
Thus, the answer to the question appears to depend on the 
date that breaks the early and later sample periods. If the break 
date is 1980, then both A and   are important. If the break 
date is 1984, then only   is important. As mentioned above, 
estimates of the date of the reduction in output volatility 
generally point to 1984. However, as Stock and Watson (2002) 
show, this break date is very imprecisely estimated. They find 
confidence intervals for the break date that encompass 
essentially all of the 1980s. Thus, it seems that there is not a 
definitive answer to this question.
Σ u
Σ u
Σ u
Σ u
Changes in the Impulse Response 
of Monetary Policy Shocks 
Boivin and Giannoni find that monetary policy shocks have 
changed in two important ways: first, they are smaller in the 
1980s and 1990s than in the earlier period (Table 4 of their 
paper); second, their dynamic response on output (the impulse 
response function) is attenuated in the later sample period 
(Chart 1 of the paper). Mechanically, this second change must 
arise from a change in the structural VAR coefficients, and the 
authors conclude that the major source of the change is a 
change in the coefficients in the interest rate equation. While 
the answer to the first question depends on the break date used 
to split the sample, the answer to this question does not. The 
paper’s Charts 2 and 3 suggest that this conclusion is robust to 
the sample splitting date.
Relationship between the Questions
Is there a tight relation between the two questions addressed in 
the paper? That is, are changes in the monetary policy shock or 
its impulse function an important cause of the change in the 
variability in output? Tables 3 and 4 in the paper suggest that 
changes in monetary policy shocks cannot be a major cause of 
the reduction in output volatility. The variance of output fell from 
5.1 in 1963-79 to 1.13 in 1984-97. The variance decomposition in 
Table 4 suggests that monetary policy shocks were responsible 
for roughly 20 percent of the variance in 1963-79, and, as 
Leeper, Sims, and Zha (1996) and Bernanke and Boivin 
(forthcoming) argue, this is probably an overestimate of the 
importance of monetary policy shocks for the variance of 
output. But, even using this value, a complete elimination of 
monetary policy shocks would have resulted in a fall in the 
variance of output from 5.1 to 4.1; this is a long way from the 
fall to 1.13 observed in the data. Thus, it seems that monetary 
shocks cannot be an important part of the story.
But this is not to say that monetary policy cannot be behind 
the drop in variability. The primary role of monetary policy is 
not to add new shocks to the macroeconomy, but rather to 
react to shocks arising from other sources (for example, supply 
shocks and fiscal shocks). As several authors have noted 
(Boivin 2000; Clarida, Galí, and Gertler 2000; Taylor 1999), 
monetary policy appears to have changed in a way that may 
help stabilize both output and inflation. Unfortunately, the 
Implied Standard Deviation from Sample-Specific 
Vector Autoregressions (VARs)
Variable
Sample Standard 
Deviation Standard Deviation Implied by VAR
1960-83 1984-2001
Output 2.71 1.59 2.76 1.43 1.48 2.63
Inflation 1.49 0.59 1.50 0.54 0.95 0.85
Source: Stock and Watson (2002).
Note: The first sample period is 1960-83 (estimated parameters:   and 
); the second sample period is 1984-2001 (estimated parameters:   
and ).
Xt AL ()Xt 1 – ut Var ut () Σ = , + =
σ A ˆ
1 Σˆ
1 , () σ A ˆ
2 Σˆ
2 , () σ A ˆ
1 Σˆ
2 , () σ A ˆ
2 Σˆ
1 , ()
A ˆ
1 L ()
Σˆ
1 A ˆ
2 L ()
Σˆ
2FRBNY Economic Policy Review / May 2002 115
structural VAR used in this paper, which isolates only the 
monetary policy shock, is not well suited for investigating this 
question, which requires isolating all of the important 
structural shocks. A complete structural model seems to be 
required, and a promising candidate for this purpose is 
developed in Boivin and Giannoni (2002).References
116 Commentary 
Ahmen, S., A. Levin, and B. Wilson. 2001. “Recent U.S. Macro-
economic Stability: Good Luck, Good Policies, or Good Practices?” 
Unpublished paper, Board of Governors of the Federal Reserve 
System.
Bernanke, B., and J. Boivin. Forthcoming. “Monetary Policy 
in a Data-Rich Environment.” Journal of Monetary 
Economics.
Boivin, J. 2000. “The Fed’s Conduct of Monetary Policy: Has It 
Changed and Does It Matter?” In Essays on the Analysis 
of Changes in the Conduct of Monetary Policy, Chapter 3. 
Ph.D. dissertation, Princeton University.
Boivin, J., and M. Giannoni. 2002. “Has Monetary Policy Become Less 
Powerful?” Federal Reserve Bank of New York Staff Reports, 
no. 144, March.
Chauvet, M., and S. Potter. 2001. “Recent Changes in the U.S. Business 
Cycle.” Federal Reserve Bank of New York Staff Reports,
no. 126, May.
Clarida, R., J. Galí, and M. Gertler. 2000. “Monetary Policy Rules 
and Macroeconomic Stability: Evidence and Some Theory.” 
Quarterly Journal of Economics 115, no. 1 (February):
147-80.
Kim, C., C. Nelson, and J. Piger. 2001. “The Less Volatile U.S. 
Economy: A Bayesian Investigation of Breadth, and Potential 
Explanations.” Unpublished paper, Board of Governors 
of the Federal Reserve System.
Leeper, E. M., C. A. Sims, and T. Zha. 1996. “What Does Monetary 
Policy Do?” Brookings Papers on Economic Activity, no. 2: 
1-63. 
McConnell, M. M., and G. Perez-Quiros. 2000. “Output Fluctuations 
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In J. Taylor, ed., Monetary Policy Rules. Chicago: University 
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The views expressed are those of the author and do not necessarily reflect the position of the Federal Reserve Bank of New York 
or the Federal Reserve System. The Federal Reserve Bank of New York provides no warranty, express or implied, as to the 
accuracy, timeliness, completeness, merchantability, or fitness for any particular purpose of any information contained in 
documents produced and provided by the Federal Reserve Bank of New York in any form or manner whatsoever.

An Historical Analysis of Monetary Policy Rules.” In

Has Monetary Policy Become Less Powerful?” Federal Reserve Bank of New York Staff Reports,

Has the Business Cycle Changed and Why?” Unpublished paper,

Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory.”

Output Fluctuations in the United States: What Has Changed since the Early 1980s?”

Recent Changes in the U.S. Business Cycle.” Federal Reserve Bank of New York Staff Reports,

Recent U.S. Macroeconomic Stability: Good Luck, Good Policies, or Good Practices?” Unpublished paper,

The Fed’s Conduct of Monetary Policy: Has It Changed and Does It Matter?”

The Less Volatile U.S. Economy: A Bayesian Investigation of Breadth, and Potential Explanations.” Unpublished paper, Board of Governors of the Federal Reserve System.

The Long Boom.”

Assessing changes in the monetary transmission mechanism: a VAR approach : commentary

http://www.newyorkfed.org/research/epr/02v08n1/0205wats.pdf

Assessing changes in the monetary transmission mechanism: a VAR approach : commentary

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