Assessing the Transmission of Monetary Policy Using Time-varying Parameter Dynamic Factor Models

• Published in: Oxford bulletin of economics and statistics Vol. 75; no. 2; pp. 157 - 179
• Main Author: Korobilis, Dimitris
• Format: Journal Article
• Language: English
• Published: Oxford, UK Blackwell Publishing Ltd 01.04.2013; Wiley-Blackwell
• Subjects: Augmentation; Coefficients; Covariance; Endogenous; Exchange rates; Foreign exchange rates; GDP; Gross Domestic Product; Inflation; Monetary policy; Money; Post World War II period; Stochastic models; Studies; Transmission mechanism; Variables; Vector-autoregressive models; Volatility; United States > US
• ISSN: 0305-9049; 1468-0084
• DOI: 10.1111/j.1468-0084.2011.00687.x

This article extends the current literature which questions the stability of the monetary transmission mechanism, by proposing a factor‐augmented vector autoregressive (VAR) model with time‐varying coefficients and stochastic volatility. The VAR coefficients and error covariances may change gradually in every period or be subject to abrupt breaks. The model is applied to 143 post‐World War II quarterly variables fully describing the US economy. I show that both endogenous and exogenous shocks to the US economy resulted in the high inflation volatility during the 1970s and early 1980s. The time‐varying factor augmented VAR produces impulse responses of inflation which significantly reduce the price puzzle. Impulse responses of other indicators of the economy show that the most notable changes in the transmission of unanticipated monetary policy shocks occurred for gross domestic product, investment, exchange rates and money.