Dissertation Defenses

Doctoral Dissertation Announcement

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Candidate: Dawit Legesse Senbet

Degree of: Doctor of Philosophy

Department: Economics

Title: Estimating the Impact, Transmission Mechanism and Reaction Function of Monetary Policy: A Factor- Augmented Vector Autoregressive (FAVAR) Approach

Committee:
Dr. Mark Wheeler, Chair
Dr. C. James Hueng
Dr. Kevin Corder

Date: Monday, July 30, 2007 10:00 a.m. – 12:00 p.m.
5302 Friedmann Hall

Abstract:
This dissertation employs factor-augmented vector autoregressive (FAVAR) models to investigate the impact, transmission mechanism and reaction function of monetary policy. The recent development of augmenting dynamic factor analysis with the vector autoregressive (VAR) models, pioneered by Bernanke et al. (2005), has led to advances in monetary policy analysis. The new approach bases measurements of monetary policy impacts, or responses, on large data sets that approximate the true information set of policymakers. This is in contrast to low dimensional VAR models. With the new technique, information from a large data set is summarized by a few factors that are incorporated into VAR models.
In the first essay, I investigate the impact of monetary policy on a wide range of macroeconomic indicators for the United States, Canada, the U.K., Japan and France using FAVAR models. I also examine the international transmission of monetary policy, i.e., the influence of United States’ monetary policy on the other countries in the sample. This essay incorporates between 70 and 80 monthly macro variables for each country. The results show that first, augmenting the VAR model with factors eliminates the “price puzzle” response (inflationary response to contractionary monetary policy) evident in the standard VAR models for all countries. Second, monetary policy has generally plausible impacts on a wide range of economic variables. Third, there is evidence of strong United States’ monetary policy influence on Canada. The United States’ monetary policy also mildly affects the U.K. and Japan.
In the second essay, I investigate the channels of monetary policy transmission in the United States using the FAVAR models. This essay builds on the debates of whether monetary policy works through the credit channel in addition to the traditional interest rate channel. I include 154 monthly U.S. time series variables for the period 1970–2003. The findings support the existence of the credit channel in the United States. The conclusion remains the same when the nonborrowed reserve operating regime (October 1979–October 1982) is removed from the estimation period.
The third essay builds on the seminal work of Taylor (1993), and uses “Taylor rules” to study the reaction functions of monetary policymakers in the United States, Canada, the U.K. and Japan. FAVAR models are used to conduct the analysis. The Taylor rule states that central bankers increase the nominal interest rate if inflation is above the target (inflation gap) and/or output is above the potential (output gap). However, many recent studies indicate that policymakers follow and analyze hundreds of variables before they make policy decisions. Therefore, one could naturally expect that policymakers might react to many variables in addition to inflation and output gaps. Depending on the country examined, I include monthly data on 80 to 150 macro variables in the FAVAR model to investigate the policy reaction functions. The findings show that monetary policymakers indeed react to the inflation gap and the output gap. However, they also react to many other key variables, including (but not limited to) capacity utilization rates, unemployment rates, monetary aggregates (M1 or M2), exchange rates and long-term interest rates.