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Please note you do not have access to teaching notes, monetary policy and market interest rates: literature review using text analysis.

International Journal of Development Issues

ISSN : 1446-8956

Article publication date: 17 August 2021

Issue publication date: 25 August 2021

This paper aims to examine the relationship between monetary policy and market interest rates. This paper examines the efficiency of interest rate channel used in monetary regulation as well as implementation of monetary policy under low interest rates. This paper examines and reviews the scientific literature published over the past 30 years to determine primary research areas, to summarize their results and to identify appropriate measures of monetary policy to be used in practice in changing economic environment.

Design/methodology/approach

This paper reviews 94 studies focused on the relationship between monetary policy and market interest rates in terms of meeting the goals of macroeconomic regulation. The articles are selected on the basis of Scopus citation and bibliometric analysis. A major feature of this paper is the use of text analysis (data preparation, frequency of terms and collocations use, examination of relationships between terms, use of principal component analysis to determine research thematic areas). Using the method of principal component analysis while studying abstracts this paper reveals thematic areas of the research. Thus, the conducted text analysis provides unbiased results.

First, this paper examines the whole complex of relationships between monetary policy of central banks and market interest rates. Second, this research reviews a wide range of literature including recent studies focused on specific features of monetary policy under low and negative rates. Third, this study identifies and summarizes the thematic areas of all the researches using text analysis (transmission mechanism of monetary policy, efficiency of zero interest rate policy, monetary policy and term structure of interest rates, monetary policy and interest rate risk of banks, monetary policy of central banks and financial stability). Finally, this paper presents the most important findings of the studied articles related to the current situation and trends on the financial market as well as further research opportunities. This paper finds the principal results of studies on significant issues of monetary policy in terms of its efficiency under low interest rates, influence of its instruments on term structure of interest rates and role of banking sector in implementation of transmission mechanism of monetary policy.

Research limitations/implications

The limitation of the review is examining articles for the study period of 30 years.

Practical implications

Central banks of emerging economies should apply the instruments and results of the countries' monetary policies reviewed in this paper. Using text analysis this paper reveals the main thematic areas and summarizes findings of the articles under study. The analysis allows presenting the main ideas related to current economic situation.

Social implications

The findings are of great value for adjusting the monetary policy of central banks. Also, these are important for people because these show the significant role of monetary policy for the economic growth.

Originality/value

Using text analysis this paper reveals the main thematic areas (transmission mechanism of monetary policy, efficiency of zero interest rate policy, monetary policy and term structure of interest rates, monetary policy and interest rate risk of banks, monetary policy of central banks and financial stability) and summarizes findings of the articles under study. The analysis allows defining the current ideas relevant to the monetary policy of developing countries. It is important for central banks because it examines the monetary policy problems and proposes optimal solutions.

• Monetary policy
• Interest rates
• Interest rate channel

Acknowledgements

The authors would like to thank the Associate Professor Ludmila Vinogradova for assistance in translation and Fedor Fedorov for help in text analysis.

Fedorova, E. and Meshkova, E. (2021), "Monetary policy and market interest rates: literature review using text analysis", International Journal of Development Issues , Vol. 20 No. 3, pp. 358-373. https://doi.org/10.1108/IJDI-02-2021-0049

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Monetary Policy Announcements, Information Shocks, and Exchange Rate Dynamics

• Research Article
• Open Access
• Published: 22 August 2022
• volume  34 ,  pages 341–369 ( 2023 )

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• Daniel Gründler 1 ,
• Eric Mayer 2 &
• Johann Scharler 1  

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Cite this article

We study nominal exchange rate dynamics in the aftermath of U.S. monetary policy announcements. Using high-frequency interest rate and stock price movements around FOMC announcements, we distinguish between pure monetary policy shocks and information shocks, which are associated with new information contained in the announcements. Contractionary pure policy shocks give rise to a strong, but transitory, appreciation on impact. Information shocks also appreciate the exchange rate, but the effect builds up only slowly over time and is highly persistent. Thus, we conclude that although the short-run effects on the exchange rate are primarily due to pure policy shocks, the medium-run response is driven by information effects.

Avoid common mistakes on your manuscript.

1 Introduction

In this paper, we study the response of the U.S. Dollar to information shocks and pure monetary policy shocks in the context of FOMC announcements. Although the effects of monetary policy on exchange rates have been studied in a number of contributions, typically against the backdrop of the Dornbusch ( 1976 ) landmark contribution, the overshooting hypothesis (see e.g. Rüth  2020 ; Inoue and Rossi  2019 ; Bjørnland  2009 ; Scholl and Uhlig  2008 ), Footnote 1 information shocks associated with central bank announcements as a source of exchange rate fluctuations have received less attention. As central bank announcements typically reveal news about the central bank’s assessment of the state of the economy (see e.g. Campbell et al. 2012 ; Nakamura and Steinsson 2018 ; Jarocinski and Karadi 2020 ), financial market participants closely monitor and process information provided by central banks. Thus, information shocks may be a source of exchange rate fluctuations.

A number of recent contributions emphasize the role of information effects for the transmission of monetary policy more generally (Cieslak and Schrimpf  2019 ; Jarocinski and Karadi 2020 ; Andrade and Ferroni  2021 ). Market participants may interpret contractionary (expansionary) policy announcements as the central bank’s reaction to an improved (worsened) economic outlook, which may give rise to more optimistic (pessimistic) views regarding the overall macroeconomic situation. Consider the following example: On January 30th, 2008 the Federal Reserve announced a reduction of the federal funds rate target by 50 basis points. This announcement resulted in a decline in the 3-month federal funds future and although standard textbooks predict an increase in equity prices in such a case, the S&P500 declined as well. The announcement was accompanied by the following statement (Federal Reserve  2008 ): ”Financial markets remain under considerable stress, and credit has tightened further for some businesses and households. Moreover, recent information indicates a deepening of the housing contraction as well as some softening in labor markets.” Thus, the decline in stock prices, despite the lower federal funds rate target, may have been the result of information effects, i.e. more pessimistic expectations due to the information conveyed with the announcement.

To study how information shocks influence exchange rate dynamics, we disentangle pure monetary policy shocks and information shocks by imposing sign restrictions on high-frequency changes in interest rates and stock prices measured within short time windows around central bank announcements. The main identifying assumption is that a pure policy shock results in a negative co-movement of high-frequency changes in interest rates and stock prices, while an information shock gives rise to a positive co-movement (Jarocinski and Karadi  2020 ; Jarocinski  2020 ; Kerssenfischer  2019 ). Intuitively, a contractionary pure policy shock should lead to higher interest rates and lower expected discounted dividends, which in turn leads to lower stock prices. However, if stock prices increase, despite a monetary tightening and higher interest rates, then the stock market movement is likely to reflect a more optimistic assessment by the central bank conveyed with the policy announcement. Based on these identifying assumptions, we decompose the high-frequency interest rate change into pure policy and information components using rotational sign restrictions as in Jarocinski ( 2020 ). The fact that changes in interest rates and stock prices are measured within short windows around announcements ensures that these changes reflect surprises associated with the announcement (Kuttner  2001 ; Gürkaynak et al. 2005 ). As a next step, we use the pure policy and information surprise components as instruments in a proxy VAR as in Gertler and Karadi ( 2015 ). Footnote 2

Our results show that, not accounting for information effects, contractionary monetary policy shocks give rise to a sharp appreciation followed by a persistent depreciation of the nominal effective exchange rate consistent with the overshooting model of Dornbusch ( 1976 ) and in line with empirical evidence presented in e.g. Bjørnland ( 2009 ) and Rüth ( 2020 ). Although pure monetary policy and information shocks both contribute to the appreciation, the dynamic patterns induced by these two shocks differ strongly. A pure monetary policy shock appreciates the U.S. Dollar in the short run, but the effect is transitory, in line with the overshooting model. The exchange rate response to an information shock, in contrast, is rather muted on impact but becomes more pronounced over the medium run, resulting in a persistent appreciation. Thus, the behavior of the exchange rate conditional on the information shock is reminiscent of delayed overshooting dynamics in the spirit of Eichenbaum and Evans ( 1995 ) and Scholl and Uhlig ( 2008 ).

To explore these delayed overshooting patterns in greater detail, we estimate the responses of ex-post deviations from uncovered interest rate parity (UIP). Footnote 3 While previous papers such as Müller et al. ( 2019 ) or Rüth ( 2020 ) include similar exercises, they do not distinguish between policy and information shocks. Despite the persistent exchange rate response after an information shock, we do not detect any noteworthy reactions of UIP deviations neither to the information shock nor to the pure policy shock. Thus, the exchange rate and interest rates jointly adjust in line with UIP, despite stark differences in the exchange rate responses. That is, the persistent exchange rate response to the information shock is accompanied by appropriate changes in interest rates, which is in line with a number of recent studies that document persistent effects of information shocks on interest rates. Footnote 4

Although the exchange rate response triggered by the information shock is less precisely estimated, the historical decomposition shows that due to the higher persistence of its effects, which accumulate over time, the information shock contributes substantially to exchange rate dynamics. To the extent that persistent changes in the exchange rate are likely to induce more pronounced effects on the economy, our results suggest that the implications of exchange rate fluctuations should crucially depend on the type of shock that gives rise to these fluctuations. Footnote 5 In fact, it may be primarily new information about the macroeconomic environment, rather than the announcement of the actual policy itself, that results in sizeable effects associated with policy-induced variations in the exchange rate.

Given the strong influence of information shocks on exchange rate dynamics, our findings suggest that accounting for the potentially counteracting effects that the information revealed by central bank announcements exerts, contributes to a better understanding of exchange rate movements overall. In addition, our estimates may help to calibrate structural models of the monetary transmission mechanism, which increasingly incorporate information shocks (e.g. Jarocinski and Karadi  2020 ).

Our analysis is related to several strands of the literature. The response of the exchange rate to monetary policy shocks has been studied in a number of contributions. Several papers analyze whether exchange rate dynamics are consistent with the exchange rate overshooting model of Dornbusch ( 1976 ). Eichenbaum and Evans ( 1995 ) and Grilli and Roubini ( 1995 , 1996 ) find evidence for delayed overshooting, i.e., a smaller response of the exchange rate in the short term than in the long term (see also Froot and Thaler  1990 ). Similarly, MacDonald and Popiel ( 2020 ) use ordering restrictions to identify unconventional monetary policy shocks in the U.S and Canada and find that the bilateral exchange rate response reaches its maximum only after more than a year following an U.S. policy shock. The maximum response after a Canadian unconventional policy shock is reached closer to the impact period, however. Scholl and Uhlig ( 2008 ) use sign restrictions to identify policy shocks and find that the maximum appreciation occurs only after 1 to 2 years. In contrast, Faust and Rogers ( 2003 ) estimate the maximum exchange rate responses at horizons that are close to the impact period. Dery and Serletis ( 2021 ) obtain similar results using a combination of zero and sign restrictions for identification. Bjørnland ( 2009 ) identifies monetary policy shocks by imposing long-run monetary neutrality restrictions and finds real exchange rate responses consistent with Dornbusch ( 1976 ) for a number of countries. Inoue and Rossi ( 2019 ) identify monetary policy shocks as changes in the whole yield curve in response to monetary policy surprises and also find support for exchange rate overshooting. Müller et al. ( 2019 ) use narrative monetary policy shocks and a local projections framework and find evidence in favor of delayed overshooting. In contrast to these studies, we use a high-frequency identification approach and emphasize the role of new information conveyed at central bank announcements.

Methodologically, our paper is most closely related to Rogers et al. ( 2018 ) and Rüth ( 2020 ). These two contributions use proxy VARs in combination with high-frequency instruments to identify policy shocks and find evidence in favor of overshooting. While these authors do not explicitly consider information shocks, we contribute to this branch of the literature by exploring the exchange rate effects of new information conveyed at central bank announcements. Footnote 6

The paper is structured as follows: Sect. 2 describes our econometric approach and the data we use in our estimations. Section  3 presents our main findings, which include impulse response functions as well as a historical decomposition. Afterwards, Sect. 4 contains a battery of robustness checks and finally, Sect. 5 concludes.

2 Estimation and Data

We estimate the following reduced-form VAR model:

where y t is the vector of endogenous variables, c is a vector of constant terms, the matrices B j contain the autoregressive coefficients, and u t is a vector of error terms with u t ∼ N (0 , Σ). We set p = 6 in our baseline specification. Footnote 7

The choice of endogenous variables closely follows Gertler and Karadi ( 2015 ) and Jarocinski and Karadi ( 2020 ). Footnote 8 We include the 1-year government bond yield (GS1) as a policy indicator, which should be affected by conventional policy and forward guidance. As the main macroe- conomic variables, we use industrial production (IP) and the consumer price index (CPI). To capture financial markets financial conditions as channels for policy transmission, we include the S&P500 stock market index (S&P500) and the excess bond premium (EBP). And finally, we include the spot nominal effective exchange rate index (NEER).

We take logs of IP, CPI, S&P500, and the exchange rate index and multiply the resulting series by 100. The remaining series are included without any transformations. While we focus on the NEER in our baseline analysis, we also estimate the model with bilateral exchange rates and excess returns that measure deviations from the UIP in Sect.  3.2 . We define spot exchange rates as the price of one unit of foreign currency in terms of U.S. Dollars. The data ranges from 1984M2 to 2016M12. Footnote 9 Table 1 provides details about the variables and the data sources.

We apply a high-frequency identification approach and use pure policy and information surprises as instruments in a proxy VAR (Gertler and Karadi  2015 ; Caldara and Herbst  2019 ; Paul  2020 ; Swanson  2021 ). In contrast to ordering and sign restrictions on the impulse response functions, the high-frequency identification approach has the advantage that no restrictions on impulse response functions are needed, which allows us to remain agnostic with respect to how the endogenous variables respond to pure policy and information shocks. An additional advantage of the proxy VAR is that it can account for measurement error in the surprise measures that could bias the estimated impulse responses (Rüth  2020 ). And although high-frequency identification can be combined with a Cholesky decomposition (Plagborg-Møller and Wolf  2021 ), the proxy VAR has the advantage that we can estimate the model using a sample that starts in 1984, although data for the instruments are only available from 1990M2 on. By doing so, we obtain more efficient estimates (Gertler and Karadi  2015 ; Rüth  2020 ).

To construct instruments, we use high-frequency changes in interest rates and stock prices between 10 minutes before and 20 minutes after a FOMC announcement, which we take from Jarocinski and Karadi ( 2020 ). Specifically, we use the 3-month federal funds future rate as an interest rate surprise. Gertler and Karadi ( 2015 ) and Jarocinski and Karadi ( 2020 ) emphasize that this series comprises surprises in actual policy rate changes as well as a short term forward guidance component. As a stock market surprise, we use the S&P500 index, as is standard in the literature (e.g. Cieslak and Schrimpf  2019 ; Jarocinski and Karadi  2020 ). Since only the announcement by the central bank should have a systematic effect on interest rates and financial market variables within such a short time period, these high-frequency changes can be interpreted as broad policy surprises, i.e., they should be correlated with the pure policy shock and the information shock but not with other shocks (see e.g. Kuttner  2001 ; Gürkaynak et al. 2005 ; Hamilton  2008 ; Miranda-Agrippino  2016 ). The surprise series are based only on scheduled FOMC meetings between 1990M2 to 2016M12. Footnote 10

We decompose the interest rate surprise into two orthogonal components: the pure policy surprise, mp t , and the information surprise, cbi t . To do so, we impose two key identifying assumptions. Footnote 11 First, we assume that a pure policy shock gives rise to a negative co-movement of interest rate and stock price surprises. A pure policy shock typically induces contractionary effects on the economy, resulting in lower expected dividends. In addition, the lower future dividends are discounted at a higher rate. Both these effects should lead to a decline in stock market prices. Indeed, there is strong empirical evidence that a contractionary policy shock is followed by lower stock market prices (Miranda-Agrippino and Ricco  2018 ; Paul  2020 ; Swanson  2021 ).

The second key identifying assumption is that an information shock moves interest rate and equity prices in the same direction. The central bank typically has an informational edge over private market participants (Romer and Romer  2000 ), and central bank announcements convey part of the central bank’s private information. The announcement of a policy contraction, for instance, may be a response to an improved economic outlook. Market participants may therefore interpret such an announcement as a signal for an economic outlook that is better than previously expected. In line with this argument, Campbell et al. ( 2012 ) and Mitchell and Pearce ( 2020 ) find that contractionary policy announcements increase inflation and output growth expectations of private forecasters. Since this implies expansionary effects, we assume that stock market prices increase as a result. This assumption is backed up by empirical studies that find higher stock prices after an interest rate increasing information shock (see e.g. Miranda-Agrippino and Ricco  2018 ; Kerssenfischer  2019 ; Jarocinski and Karadi  2020 ).

Of the 161 FOMC announcements in our sample that have a non-zero effect on the surprises in the federal funds rate future and the S&P500, 53 are characterized by a positive co-movement of these surprise measures. In other words, about a third of these policy announcements lead to a financial market reaction that is consistent with what we would expect after a central bank information shock.

We follow Jarocinski ( 2020 ) and use rotational sign restrictions to decompose the interest rate surprise into a pure policy component and an information component, Footnote 12 and we use the orthogonalized surprises as instruments for the shocks of interest in the proxy VAR. Footnote 13 As a starting point for the rotational sign restrictions approach, we define a T + p × 2 matrix M that contains the monthly aggregated high-frequency changes in the 3-month federal funds future rate, i , and in the S&P500, s , and where T is the sample size. To decompose i into two orthogonal components mp and cbi , we first calculate the QR-decomposition of M , such that:

where I 2 is an identity matrix of dimension 2 and the diagonal elements in R are restricted to be positive. Next, we rotate the orthogonal components in Q using the following rotation matrix:

where α is the inverse cosine of \(\sqrt[2]{\lambda }\) . To determine λ , we follow Jarocinski ( 2020 ) and define a modified vector of interest rate surprises where we set the values in the vector i to zero if both surprises have the same sign, as this indicates a dominant information shock in period t . This is essentially the poor man’s sign restriction approach discussed in Jarocinski and Karadi ( 2020 ) as an alternative method to disentangle pure policy and information shocks. Using this vector of modified surprises, we calculate λ as the variance associated with the non-zero entries in this vector relative to the variance of the original vector i . And based on this value for λ , which is 86 percent, we calculate α . Footnote 14

Finally, we use the following matrix D to scale the orthogonalized surprises such that they add up to the broad policy surprise i :

Combining these steps, we calculate the orthogonalized surprises as [ mp, cbi ] = QPD and use these two surprises as instruments for the 1-year government bond yield in a proxy VAR. As in Montiel Olea et al. ( 2021 ), we calculate the impact responses to the two orthogonal shocks as:

where u p is a vector containing the residuals in the policy indicator equation and mp and cbi are vectors including the pure policy surprise respectively the information surprise. Footnote 15 The two coefficients δ mp and δ cbi capture the contemporaneous effects of the pure policy shock and the information shock on the variables in the system. We scale these coefficients such that each of the identified shocks induces a unit increase in the 1-year government bond yield on impact.

The Wald-statistics for the covariance between our instruments and the residuals in the policy indicator equation as well as for the covariance between the instruments and the full vector of reduced form residuals suggest that our instruments are relevant. Finally, we follow Montiel Olea et al. ( 2021 ) and use the delta-method to calculate asymptotically valid confidence bands. Footnote 16

3.1 Effective Exchange Rate

Figure 1 displays the main results. The solid lines show the point estimates and the shaded areas represent 68 percent and 90 percent confidence bands. As a first analysis, we show the responses to a broad policy shock, that is, without taking information effects into account, in the first column of the figure. A contractionary monetary policy shock gives rise to persistent declines in industrial production and the CPI. While the stock market declines, the 1-year bond yield and the excess bond premium increase, indicating tighter financing conditions. These responses are in line with the existing literature (see e.g. Gertler and Karadi  2015 ; Miranda-Agrippino and Ricco  2018 ; Caldara and Herbst  2019 ). The exchange rate appreciates significantly in effective terms on impact and in the first month after the shock. This initial appreciation is followed by a slow and highly persistent depreciation back to the pre-shock level. Since the maximum response, which is about 5 percent, occurs within the first quarter after the shock, we interpret these dynamics as being in line with the exchange rate overshooting model of Dornbusch ( 1976 ) and with the empirical evidence presented in Rüth ( 2020 ) and Bjørnland ( 2009 ), among others.

IRFs, BL Model

Next, we distinguish between pure policy shocks and information shocks. The responses to a pure policy shock are displayed in the second column of Figure 1 and the third column shows the responses to an information shock. The pure policy shock induces contractionary effects, with persistent declines in production, consumer prices and equity prices as well as tightened financing conditions. The information shock, in contrast, exerts only a small effect on industrial production, but leads to higher consumer prices. Stock market prices increase and the lower excess bond premium declines.

Turning to the exchange rate, we see that although the exchange rate appreciates in response to either of the two shocks, the timing of the effects differs strongly. While the maximum response to the pure shock occurs close to impact, as in the case of the broad shock, the response is less persistent than in the first column of the figure, where the point estimate remains below zero for all horizons shown in the figure. The information shock has essentially no effect on the exchange rate in the short run, but the effect builds up over time and becomes more pronounced over the medium run and reaches its maximum roughly 2 years after the shock. Thus, for the case of the information shock we detect a persistent appreciation that is reminiscent of delayed overshooting dynamics. In general, the more persistent response of the exchange rate to an information shock is in line with the interest rate responses shown in Figure 1 . The information shock generates an interest rate response that is substantially more persistent than the response to the pure shock, a result which is well-documented in the recent literature (see e.g. Jarocinski and Karadi  2020 ; Breitenlechner et al. 2021 ; Pinchetti and Szczepaniak  2021 ). Still, the delayed exchange rate appreciation that follows an information shock hints at a violation of the UIP condition. Footnote 17

Although the medium-run response of the exchange rate to the information shock is of a similar order of magnitude as the short-run response to the pure policy shock, it is somewhat less precisely estimated as indicated by the rather wide confidence bands at higher horizons. Still, the response is significant on the 68% level, indicating a systematic effect of the information shock on the exchange rate. Overall, it appears that the persistence of the response to the broad shock in the first column is largely the result of information effects.

To compare the contributions of pure policy and information shocks quantitatively, Fig.  2 presents the historical decomposition of the nominal effective exchange rate, which we obtain by following the approach suggested in Montiel Olea et al. ( 2021 ). The figure depicts the nominal effective exchange rate (black line) on the right axis together with the contributions of the two identified shocks on the left axis. It has to be noted that since the two shocks are only identified up to a scaling factor, only the relative size of the contributions can be interpreted.

BL model, historical decomposition of effective exchange rate

Figure 2 shows that the contributions of the pure policy shock fluctuate stronger than those associated with the information shock, which is likely due to the substantially more persistent effects generated by the information shock, as discussed above. In other words, the figure indicates that pure policy shocks are more relevant when the exchange rate is subject to sharp, but short-lived movements, such as the appreciation in late 2008. Longer-lasting movements, in contrast, are primarily due to the slowly accumulating effects of the information shock.

3.2 Bilateral Exchange Rates and Deviations from UIP

To study the effect of monetary policy on foreign exchange markets in more detail and take potential heterogeneities into account, we now estimate separate VAR models including bilateral exchange rates. To do so, we replace the effective exchange rate index by either the British Pound, the Japanese Yen, or the Canadian Dollar exchange rate. Footnote 18

Figure 3 displays responses of these bilateral exchange rates after broad and pure policy shocks as well as information shocks. Footnote 19 We see that the appreciation of the Dollar against the British Pound is more persistent compared to the other exchange rates. And while the persistence is again strongly driven by the information shock in this case, the response to the pure shock is also more persistent than for the other exchange rates. The figure also shows that although the information shock gives rise to a delayed appreciation in general, with only small effects on impact, the U. S. Dollar initially depreciates against the Canadian Dollar, which is partly the reason for the dampened impact response to the broad policy shock. Nevertheless, over time the U.S. Dollar appreciates slowly in response to the information shock, similar to our baseline results. Overall, we conclude that the results for bilateral exchange exchange rates are largely similar to our findings for the nominal effective exchange rate.

IRFs, different exchange rates

A central assumption in the overshooting model of Dornbusch ( 1976 ) is that UIP holds. Hence, we can interpret the delayed overshooting patterns that we observe in Fig.  3 in response to an information shock as an indication of a violation of the UIP, conditional on the information shock. UIP implies that the interest rate differential between foreign and U.S. interest rates is offset by an expected depreciation of the dollar exchange rate over the holding period of a bond. Any deviation from the UIP gives rise to ex-post excess returns for investors who short the currency with the lower interest rate to benefit from the higher interest rates and an exchange rate appreciation implied by delayed overshooting. To perform a direct evaluation of UIP in the aftermath of policy announcements, we replace the bilateral exchange rates with ex-post deviations from UIP, re-estimate the VAR and calculate their responses to pure monetary policy and information shocks. We calculate the ex-post excess returns as:

where s t is the exchange rate, \({i}_{t-h}^{*}\) and \({i}_{t-h}\) are the annualized foreign and U.S. money market interest rates for either one month ( h = 1) or three months ( h = 3) in period t − h . The factor 1200 /h adjusts the annualized interest rate differential to either monthly or quarterly returns. As stated, a decline in s t denotes an appreciation of the Dollar. Thus, the (ex-post) return reflects the return of an investor who shortens the U.S. Dollar in t − h (home country) and goes long in the foreign currency. Proceeds from this transaction, which are composed out of the interest rate differential i ∗ − i t − h and the percentage appreciation or depreciation of the exchange rate from period t − h to t , are settled in period t . If λ h < 0, the investor receives a negative return from the transaction.

Figures 4 and 5 show the responses of the monthly and quarterly ex-post UIP deviations, respectively. We see that broad monetary policy shocks give rise to only short-lived monthly and quarterly deviations from UIP, which is in line with Rüth ( 2020 ) and Bjørnland ( 2009 ), among others. Note that the responses of the UIP deviations are conditional on the monetary policy shock and do not necessarily tell us much about whether or not UIP holds unconditionally. Footnote 20

IRFs, 1 M UIP residuals

IRFs, 3 M UIP residuals

IRFs, Model with 4 lags

IRFs, Model with 8 lags

IRFs, Model with 10 lags

IRFs, Model with 12 lags

We also see that the responses to the broad shock mirror the responses to the pure shock in the second column of the figure, similar to our findings for the exchange rate responses.

The responses to the information shock are shown in last column. Interestingly, although the exchange rate responses to the information shock in Fig.  3 are rather persistent, the UIP deviations respond only slightly more persistently to the information shock than to the pure policy shock. For the Japanese Yen, the response of the UIP deviation is somewhat more persistent, but still small. Overall, we conclude that the persistence of the exchange rate responses to the information shock is only to a small extent mirrored in the responses of the ex-post UIP deviations. This may be partly due to the fact that although the exchange rate responses display a higher degree of persistence, most of the appreciation still occurs within the first few months after the shock and the exchange remains rather stable afterwards. Thus, even in the aftermath of an information shock, the contribution of the exchange rate movement to the UIP deviation vanishes quickly.

4 Robustness Analysis

In this section, we support our results by a number of robustness checks. First, we check the sensitivity of the results to the choice of the number of autoregressive lags. Thus, Figs. 6 , 7 , 8  and 9 present results for models with p = 4, p = 8, p = 10, and p = 12 lags. For the models with higher lag orders, the error bands are somewhat wider than what we obtain with the baseline specification, which might be due to the larger number of estimated parameters. Nevertheless, our main conclusions are robust with respect to the number of included lags.

Next, we estimate two models with alternative variables measuring economic activity and prices. First, we use the unemployment rate instead of industrial production as a broader measure for economic activity. And we replace industrial production and the consumer price index with GDP and GDP deflator from Jarocinski and Karadi ( 2020 ), who use the methodology of Stock and Watson ( 2010 ) to obtain interpolated monthly series. Both, GDP and the unem- ployment rate can be considered to be broader measures for economic activity, while the GDP deflator is based on producer prices instead of consumer prices. Although these measures are highly correlated, they may still cover somewhat different components of the monetary transmission mechanism and its effect on the exchange rate. Footnote 21 Figures 10 and 11 yield responses to the broad and pure policy shock that are consistent with standard macroeconomic theory and closely resemble our baseline findings. Figure 10 suggests that the information shock leads to a decrease in the unemployment rate. Looking at the exchange rate, we see that the response is again similar to the baseline results, although the information shock induces a depreciation on impact, prior to the persistent appreciation familiar from Fig.  1 . Figure 11 shows a small expansionary GDP response following the information shock, which is somewhat in contrast to the slightly decreasing response of industrial production in Fig.  1 . Overall, the responses are similar to our baseline results.

IRFs, Model with unemployment rate

IRFs, Model with GDP and GDP Deflator

As a next step, we consider different monetary policy instruments. In particular, we replace the 3-month federal funds future surprise with the first principal component of surprises in the current month and 3-month federal funds rate and the 2-quarter, 3-quarter, and 4-quarter eurodollar future as an interest rate surprise, which we take from Jarocinski and Karadi ( 2020 ). Footnote 22

This surprise measure contains forward guidance elements to a larger degree. Footnote 23 Figure 12 shows that the results based on this instrument are in line with our baseline results.

IRFs, Model with principal component of surprises

Finally, we consider the methodology from Jarocinski and Karadi ( 2020 ), which differs from our baseline model in several aspects. The model is estimated with Bayesian methods and a Minnesota-type prior. The surprises in the 3-month federal funds future and the S&P500 are added as endogenous variables. And although the same sign restrictions as in Sect.  2 are used, the restrictions are imposed on the responses of two surprise measures in the VAR. Apart from the two surprise measures, we use the same endogenous variables as in our baseline analysis and we set the lag length to 6. Figure 13 illustrates the results. Interestingly, despite the results are based on a relatively different methodology, they are still quite similar as in Fig.  1 . With respect to the exchange rate, our main conclusion remain valid.

IRFs, Jarocinski and Karadi ( 2020 ) Model

5 Conclusion

In this paper, we investigate exchange rate responses after policy announcements and distinguish between pure monetary policy shocks and information shocks, which are the result of new information conveyed in central bank announcements. We apply rotational sign restrictions as in Jarocinski ( 2020 ) to decompose high-frequency changes in the interest rate into a pure policy surprise and an information surprise and use these two orthogonal components as instruments in a proxy VAR to study the role of pure monetary policy and information shocks for exchange rate movements.

We find that although pure monetary policy shocks as well as information shocks give rise to exchange rate fluctuations, the dynamics generated by these two types of shock differ. Contractionary pure policy shocks evoke an appreciation on impact in line with the exchange rate overshooting model of Dornbusch ( 1976 ). While the response to pure policy shocks is initially pronounced, it is also transitory. Information shocks, in contrast, give rise to a delayed, albeit highly persistent, appreciation. And due to their persistent effects, information shocks contribute strongly to exchange rate fluctuations throughout the sample, as illustrated by a historical decomposition.

Our results suggest that the exchange rate channel of monetary policy does not only transmit pure policy shocks, but also information shocks. And these information shocks, due to their persistent effects, may play an even more prominent role than pure policy shocks in terms of macroeconomic implications. While a detailed analysis of these implications is beyond the scope of the paper, it represents an interesting avenue for future research.

Dornbusch ( 1976 ) overshooting hypothesis builds on a synthesis of the uncovered interest parity (UIP), purchasing power parity, and liquidity effects and holds that an increase in domestic interest rates relative to foreign interest rates leads to an immediate appreciation followed by a persistent depreciation of the domestic currency. A textbook treatment of the nexus of Dornbusch’s overshooting model and UIP is available in e.g. Obstfeld and Rogoff ( 1996 ).

Rogers et al. ( 2018 ) and Rüth ( 2020 ) apply proxy VARs to study exchange rate dynamics.

A number of contributions demonstrate that UIP is unconditionally violated in the data (see e.g. Fama  1984 ; Lustig and Verdelhan  2007 ; Burnside et al.  2011 ).

Several studies find that information effects exert economically significant and persistent effects on interest rates (Jarocinski  2020 ; Jarocinski and Karadi  2020 ; Breitenlechner et al.  2021 ; Pinchetti and Szczepaniak  2021 ). Andrade and Ferroni ( 2021 ) find larger interest rate responses to information shocks around policy announcements than to pure policy shocks, while Cieslak and Schrimpf ( 2019 ) find evidence that information effects on impact account for a larger share in the variance decomposition of bond yields of different maturities.

Forbes et al. ( 2018 ) distinguish between different types of macroeconomic shocks and find that the degree of exchange rate pass-through depends on the shock. Although the analysis does not disentangle pure policy and information shocks, it shows that the type of shock triggering exchange rate adjustments matters for their implications.

Although Rüth ( 2020 ) and Müller et al. ( 2019 ) include estimations with policy shocks purged from information effects, they do not analyze the implications of the information shock itself.

Although information criteria suggest lower lag orders (AIC: 4 lags and BIC: 2 lags), we use 6 lags to appropriately capture the dynamics of the endogenous variables in our baseline estimation, taking into account that information criteria may underestimate the true lag length (Kilian  2001 ; Kilian and Lütkepohl  2017 ). In the robustness analysis we show that our results are not sensitive to the lag order.

In the robustness analysis we consider alternative sets of endogenous variables.

The start of the sample coincides roughly with the beginning of the Great Moderation and the end date is determined by the availability of high-frequency data.

Nakamura and Steinsson ( 2018 ) argue that unscheduled meetings may be arranged in response to other macroeconomic shocks and that these meetings should therefore be excluded. In addition, if unscheduled meetings are not expected by market participants, the pre-meeting asset prices may not capture the expected effect of the policy announcement (Caldara and Herbst  2019 ).

See also Cieslak and Schrimpf ( 2019 ); Jarocinski and Karadi ( 2020 ), who use the same sign restrictions.

Andrade and Ferroni ( 2021 ) use a similar approach.

The approach suggested in Jarocinski and Karadi ( 2020 ) also disentangles policy and information effects, but it includes the surprise measures as internal instruments, i.e., as endogenous variables, which is not compatible with a proxy VAR. As a robustness analysis, we analyze information effects using the approach suggested in Jarocinski and Karadi ( 2020 ).

Other approaches, such as the standard sign restrictions approach in Jarocinski and Karadi ( 2020 ), treat every rotation consistent with the sign restrictions as equally likely, which would include all rotations calculated using values for λ ranging from 17.89 to 100 percent in our application. Thus, even extremely low values for λ would be possible, which seems rather unlikely considering our estimated variance share of λ = 86 percent as a reference (see Jarocinski  2020 , for further details).

Gertler and Karadi ( 2015 ) estimate the contemporaneous response with a two stage approach. First, they regress the residuals from the policy indicator equation on the instruments and estimate the component in the residuals predicted by the instruments. In the second stage, they regress this component on the residuals in the policy indicator equation to estimate the impact effects. Up to scale, estimating δ mp and δ cbi as in Eq. ( 5 ) is equivalent to the following approach:

where the only difference to Gertler and Karadi ( 2015 ) is that the last three equations do not include constants, since we use two surprises in a single model to identify two shocks. We also estimated responses to the shocks in two separate models containing only a single instrument as in Gertler and Karadi ( 2015 ) and obtained virtually identical responses.

Many contributions in the proxy VAR literature calculate error bands using a wild bootstrap algorithm. However, Brüggemann et al. ( 2016 ) and Jentsch and Lunsford ( 2016 ) show that error bands based on this methodology are asymptotically invalid, which is why we use the approach of Montiel Olea et al. ( 2021 ).

Unfortunately, for the case of the NEER we lack a foreign synthetic interest rate to that would allow us to study deviations from UIP. In Sect.  3.2 , we study deviations from UIP using bilateral exchange rates and corresponding interest rates.

We choose these exchange rates since we want to focus on exchange rates to other G7 countries. Due to limited data availability, we abstract from an analysis of the U.S. Dollar-Euro exchange rate and estimate the VAR with the U.S. Dollar-Japanese Yen exchange rate and with the U.S. Dollar-Canadian Dollar exchange rate with data starting in 1985M12. For more details, please see Table 1 .

In this figure we do not show the responses of the macroeconomic variables, which closely resemble the responses in the baseline model shown in Fig. 1 .

The empirical literature regularly finds unconditional deviations from UIP (see e.g. Afat and Frömmel  2021 ; Anderl and Caporale  2022 ).

The reason why we do not use these variables already in the baseline model is that GDP and GDP deflator have to be interpolated to be available at monthly frequency, while the unemployment rate may respond with a delay.

This surprise is also used in Gürkaynak et al. ( 2005 ) and Nakamura and Steinsson ( 2018 ).

A drawback of this measure is, however, that eurodollar futures are not as liquid as federal funds futures (see e.g. Jarocinski and Karadi  2020 ).

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Gründler, D., Mayer, E. & Scharler, J. Monetary Policy Announcements, Information Shocks, and Exchange Rate Dynamics. Open Econ Rev 34 , 341–369 (2023). https://doi.org/10.1007/s11079-022-09682-6

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The International Monetary System and International Financial System as an Analogy to the Copernican Heliocentric system: A simple multi-layers network model with simultaneous regime changes

The evolution of the IMS and IFS in the past several hundred years can be viewed through the lens of the Copernican heliocentric system developed over 500 years ago. We trace out the evolution across regimes of the IMS and IFS in terms of network representations of the Copernican system. We provide a simple, fully testable theoretical model whose assumptions are based on these representations. The IMS and IFS are described by a two-layer graph whose three key features (hub, core, distances) are affected by nonlinear joint regime changes linked to a technological, institutional, geopolitical and regulatory environment variable. We conclude with a discussion of some perspectives of the future of the international monetary and financial systems. Our analysis is based on economic history, theory and some resonant concepts from astrophysics.

The authors thank Joshua Aizenman, Barry Eichengreen, Harold James, Olivier Jeanne, Robert McCauley, Antoine Parent and Marc Wiedenmier for comments on earlier versions. They also thank the participants in the World Copernican Congress of Kracow (Poland, May 24-26 2023) for useful questions and remarks. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.

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Original research article, an evaluation of the impact of monetary easing policies in times of a pandemic.

• 1 School of Economics, Tianjin University of Commerce, Tianjin, China
• 2 Portsmouth Business School, University of Portsmouth, Portsmouth, United Kingdom

This article tests five major economies of the world, United Kingdom, Japan, Brazil, Chin and lastly, India, for the changes in the monetary policy decisions that have been implemented following the Covid-19 outbreak. The assessment was undertaken in the form of an event study analysis, further substantiated with a regression analysis conducted for exploring the significance of CPI and real GDP in predicting the policy interest rates in the economy. The results of the event study analysis presented that the abnormal changes in the interest rates were statistically significant in the case of the United Kingdom, Brazil, and China, while the abnormal changes were found to be statistically insignificant in the case of India and Japan.

Background of the Study

Monetary policy can be explained as the decisions and actions undertaken by the central banks to manage money supply and availability of credit in the economy. A majority of the economies, in the present-day scenario, make use of the monetary policy initiatives to foster economic growth and propel economic momentum. Among the top monetary policy tools available for the policymakers is the management of the interest rates in the economy. Policy interest rates are used to control the supply of money in the economy, in the sense that as the interest rates increase in the economy, the supply of money is limited which limits the demand of money as the acquisition of funds becomes more expensive ( 1 ). As there are inflationary pressures in the economy, the monetary policy theory dictates that the interest rates are decreased by the policymakers to enhance the production capacity and increase in the aggregate supply ( 2 ). However, inflationary and deflationary pressures in the economy are a part of the cyclical fluctuations. However, in a series of unprecedented events, the normal business cycles are disrupted by the occurrence of unprecedented events and crises which shock the normal economic flow, which bring the economic variables to a sudden standstill. The erratic consequences of the economic shocks include changes in the consumer price index or inflation and the production, aggregate supply and consumption demand in the economy ( 3 ).

Monetary policy tools, both conventional and unconventional, endeavor to bring about price stability in the economy while enabling economic growth and development. The conventional methods for controlling the monetary base in the economy entail controlling for lending and bank interest rates in the economy ( 4 ). As the economy is faced with choppy waters, the policymakers try and ensure normalcy by giving a slight push to the industries by lowering the interest rates and easing credit availability in the economy ( 5 ). This ensures that the productive capacity is brought at par, and the output gap within the economy narrows down. On the consumption end, releasing credit availability allows an increase in the consumption demand as credit availability increases the aggregate supply, lowering the general price level in the economy. This hands-on approach toward the management of credit availability allows the policymakers to maintain financial and economic stability in the face of the cyclical economic fluctuations. However, as discussed, there are several unforeseen errants or shocks, which might affect the economic operations.

Considering to the shortage of research studies examining effects of monetary policy on main economies' development in Covid-19 as well as the scarcity of the existing literature on the relationship between monetary policy with the pandemic, this study is motivated to contribute to the expansion of the existing literature on this topic by providing an evidence from the effects of monetary policy in different countries under the Coronavirus pandemic. It aims to clarify how different economies' monetary policy are how to affect the real economy and price level within the Coronavirus pandemic. The Covid-19 pandemic is one such unprecedented event which has shaken the world economy ( 6 ). Starting off with the news associated by with viral outbreak in China began surfacing, and the world bank issued guidelines for undertaking preventive measures against the spread of the virus ( 7 ). These safeguards include the national shutdowns, import restrictions and travel restrictions which have limited the growth and productive capacity of the countries. The current article delves on the impact of the coronavirus outbreak on the monetary policy on the major world economies of the United Kingdom, Japan, Brazil, China, and India.

Review of Literature

The novel coronavirus originated in China has been declared as an emergency pandemic situation having a significant impact on the economies all over the world. The virus has impacted the output yields and investments in all industries as well as consumption among households. Generally, the policymakers, in order to contain the impact of the pandemic, use monetary policies to affect the funds available in the financial system which in turn affects the interest rate and eventually the asset prices. With the change in interest rates and asset pricing, the consumption and investment pattern changes, allowing the economy to sustain and grow. The current study discusses the impact of Covid-19 pandemic on the consumption, manufacturing, and investment in the economies of Germany, UK, and France and the influence of monetary policies of the central banks in curtailing the impact of the pandemic.

Sudden Stops and Their Impact on the Economy

Sudden stops have been studied in the empirical and theoretical literature since the late 1990s. In the times of globalization and high capital mobility, sudden stops have become a major issue in economics and international finance. The focus on sudden stops has been increased after the Global Financial Crisis of 2007–2008 with a growing literature reviewing the role of macroprudential regulation in obviating financial crisis. Sudden stops are economic fluctuations characterized by a sudden contraction or loss of capital inflows and associated irregularities due to reduced access to international financial markets. The economic term' sudden stops' was coined with the abrupt drying up of capital inflows during the Mexican crisis of 1994. The phrase was then referred in many following crises like an Argentine crisis (1995), Russian crisis (1998), the Brazilian crisis (1999), and others ( 8 ). Sudden stops are often associated with currency crashes as it results in the fall of the foreign exchange rate.

The awareness about capital inflow volatility and reversals has increased in the policy community based on which International Monetary Fund (IMF) has developed new and more sympathetic capital control as well as international capital markets intervention policies. An example of a sudden stop is the “taper tantrum” of 2013 when Federal Reserve was expected to taper its purchase of securities which would have resulted in a market crash with a rise in US interest rates leading to capital outflow from emerging economies. This suggests that sudden stops are growing disruptive. These sudden stops have real and financial implications. The financial effects occur first with depreciation in the exchange rate, a decline in reserves, and a fall in equity prices. It also leads to a deceleration in GDP growth, a slowdown in investment, and strengthening of the current account. In the first four quarters of the sudden stop, the GDP falls by 4% year on year ( 9 ). GDP declines even faster in the second subperiod demonstrating a global level shock. These financial effects can only be partially offset using macroeconomic positions.

In the 1990s, the countries responded to sudden stops by reducing the exchange rate, floating currency, and following the new exchange rate, or implement a tighter monetary policy as policy responses. These countries, in the worst-case scenario, also resort to IMF for aid in the form of fiscal tightening, trade reforms, and privatization of public enterprises ( 10 ). However, in the second phase, even less tightening of monetary and fiscal policy work. In order to support economic activity and capital markets, some companies resort to reducing policy interests. With currency depreciation, little monetary stringency would work as countries had lowered mismatches in foreign currency, reducing damage in balance sheet due to depreciation. The impact of sudden stops differs for a country with a fixed foreign exchange rate policy than for a country with a flexible foreign exchange rate policy. This is because a country with fixed exchange rate regime is not able to offset the reduction in demand through expansionary monetary policy or achieve exchange rate adjustment with the help of nominal depreciation ( 11 ). Countries with stronger fiscal balance are able to deal with the sudden stops with minimum fiscal consolidation. In the 2000s, resorting to IMF for aid was reduced as countries had accumulated a reserve of international currency and moved to flexible exchange rates.

Emerging markets have been experiencing the impact of sudden stops despite flexible exchange rates, stronger fiscal budgets, stronger financial markets, and less foreign currency differentiation. The occurrence of these sudden stops have not reduced, and any benefit from stronger fiscal and monetary positions of countries does not offset the sudden stops coming from different countries. The progress on the fiscal and monetary policies have also not reduced the implications of the stops in a significant manner ( 12 ). The output reduction in the first quarter is slightly higher than the second subperiod. With increased globalization and transaction in international financial markets, countries experience capital flow reversal more often due to sudden stops and these reversals have unruly output impacts ( 9 ). It is disturbing that neither the national officials with their monetary or fiscal policies nor the international financial institutions with their increased new financial facilities have helped in reducing the impacting of sudden stops in the emerging markets. The frequency and severity of sudden stops remain the same in all subperiods. The decline in GDP second subperiod as the capital inflows in the preceding subperiod is higher and large capital reversals are experienced when the sudden shock shift to the second subperiod. During the sudden stops, changes are observed in the global economic conditions and policies and characteristics of affected countries. Stronger policies, however, had an impact at the national level, as shown in Figure 1 . During sudden stops, it is essential for the emerging countries having high budget deficits and high inflation rate to tighten fiscal and monetary policies. According to Efremidze et al. ( 13 ), sudden stops have a negative impact on financial deficits and require governments to take painful steps to reduce the effect on financial markets. Paradoxically, exchange rate policy, tightening of monetary, and fiscal policies as a response to the stops have been found to be effective at a national level, but at the global level, the reversal of international capital flows enhances the effect of external stops. Low trade openness and low financial globalization reduces the possibility of a spillover of a sudden stop and also minimize the impact of sudden stops on the countries.

Figure 1 . Event timeline: Covid-19 pandemic.

Monetary Policy and Fiscal Stability in Pandemic Times

Covid-19 has given an economic shock to countries across the globe with its alarming speed and gigantic magnitude. This led to steep recessions in many industries across countries. Despite the global policy support, the pandemic is estimated to impact the global economy in the form of a 5.2% dip in the GDP in 2020, the highest in eight decades. The per capita incomes of emerging and developing economies have been contracted by far this year. The impact on the global economy would worsen if the pandemic took longer to get controlled and financial stress persists. The pandemic highlights the need for economic actions apart from urgent health-related policy actions to reduce the vulnerable consequences and improve the capacity of countries' system of dealing with the pandemic in future. Severe outbreaks in these countries result in international spillovers and negative impact on the global value chains and financial markets. GDP growth of regions such as Latin America, Central Asia, and Europe has been contracted due to international spillover from South Asia's GDP downgrade and the domestic outbreak of the pandemic resulting in lockdown measures. Many countries mitigated the impact of the pandemic by adopting strict fiscal and monetary policies. Per capita income is also expected to downgrade in 2020 in all emerging and developing economies. Covid-19 will leave lasting scars to the economies creating a devastating impact on the already fragile developing economies.

Monetary and fiscal policy measures can mitigate the short-term impact of the pandemic on the economy and productivity while comprehensive reforms would be required to minimize the long-term impact of the pandemic on the growth of the nation by improving governance, public health policies, and general business environment. The Covid-19 outbreak has led to a collapse in demand for oil, an upwelling oil inventories and the lowest decline in oil prices. In the initial stage of the pandemic, with all the lockdown restriction, oil prices cannot buffer the impact of Covid-19, but it can certainly help the economy to recover once the restrictions are lifted. The fiscal positions of energy-exporting emerging economies have been strained for a while now, and the pandemic has resulted in a collapse in their oil revenues. Thus, fiscal policy needs to be implemented for a sustainable economic position in a country. Recently, a sharp rise in the number of virus patients has been witnessed even in the developed economies let alone emerging and developing economies. The second wave of infection has resulted in the loss of income, trade, and investments. In these scenarios, the government fiscal policies and central bank's monetary policies are likely to renew the collapsed consumption of households. The low income restrained the borrowing capacity of households, and therefore, they could not maintain the consumption. The loose monetary policy would provide liquidity and purchasing power to the households to maintain their basic level of consumption despite a low level of savings. The ability of monetary policy and welfare systems to reduce income losses differ from country to country and is generally lower in low-income countries. The domestic investment comes to a halt during uncertainty like pandemics, and the outputs worsen. Restrictions imposed due to COVID-19 reduce the ability of fiscal and monetary policies to limit the consequences of the pandemic. Businesses are affected due to lack of demand, shortage of raw material, and costs of providing safety to employees from the virus. In some sectors, even fiscal stimulus is ineffective as the processes are completely shut ( 6 ). In such cases, the global recession is expected with high fiscal debts for low-income countries.

Role of Central Banks and Effect of Interest Rates: Delphic and Odyssean Monetary Policy Theory

The output and aggregate demand in an economy are not only influenced by the monetary policy, but interest rates also play a major role. Since interest rates have an impact on the economic policies and decisions, information revealed by the central banks about the future rates is an important medium based on which the monetary policy influence the macroeconomy.

Such impact reveals that central banks can control the aggregate demand by expressing that interest rates will remain low for a long time when the policy rate cannot be lowered due to effective lower bound (ELB). Other than the planned money supply injection and interest rates influence, sudden stops, and natural occurrences also have an influence on the yield curve. A piece of bad macroeconomic news impacts the yield curve, and as a reaction to it, the central bank needs to adjust its monetary policy. There are generally two kinds of surprises that have a macroeconomic impact on the central bank policy. As discussed by Campbell et al. ( 14 ), one of these sudden stops or natural occurrences has been termed as “Delphic” shocks as it explains the reaction of the central bank to the bad macroeconomic news by giving an oracle. The second type of shock is termed as “Odyssean” shock in which the central bank “ties its hands to the mast” by promising to twig to the announced plan for the interest rate. Central banks provide Delphic and Odyssean information even though guidance policies have been implemented. It is generally observed that Odyssean surprises are effective in improving aggregate demand and output in the economy. A central bank announcement has a Delphic nature if it raises interest rates and creates positive inflation expectations. When the inflation expectations reduce as a result of central bank announcements, Odyssean shocks occur. These announcements from a central bank not only makes the investors pessimistic or optimistic about the future of their investment, but the existence of these two shocks also helps in analyzing the response of financial and economic variables to monetary policy expectations ( 15 ). D'Amico and King ( 16 ) explained the variations and expectations of variables interest rates, output and inflation using VAR. They imposed different sign restrictions on short-term interest rate pattern as well as tracked expected inflation and GDP. This sign imposition allowed the authors to identify the domination of Delphic guidance on the Odyssean pattern

Research Gap

A wide literature discussing the impact of sudden stops such as financial crisis or pandemics on the economy and suggesting the importance of monetary easing policies in boosting money supply in the economy during the times of crisis is available. However, the specific impacts of monetary easing policies on curtailing the pandemic effects are limited specifically for the economies such as Germany, France, and the United Kingdom. Thus, the present study aims to critically assess the short-term effects of monetary easing policies on the money supply in the economy especially during the times of pandemic with consideration on the recent scenario of Covid-19. Majority of the studies have discussed the impact of monetary and fiscal policies on the economy using the VAR model. Our study would adopt a mixed methodology to answer the research questions in the context of the recent Covid-19 crisis, discussed in the following section.

Methodology

This section describes the research methodology used to answer the research questions. It explains the data and variables used and the analysis method adopted to conduct the research. It also details out the measures and methods used for analyzing data, the findings and results of which have been discussed in the following section.

Data Description

The study analyses the macroeconomic variables and financial factors of the countries UK, China, Brazil, India, and lastly Japan to evaluate the role of monetary policies in curtailing the pandemic consequences and in aiding the recovery of the economy. The monetary policies involve fixing a refinancing operations rate that is unique for every country. The study analysis considered variables with the capability of measuring economic activity such as inflation rate measured using Consumer Price Index (CPI) and real GDP. The data for real GDP was available in the form of an index with 2015 as the base year, harmonized for each of the countries being examined.

The quantitative easing in unconventional monetary policy is expected to raise inflationary pressures in the economy, which, in turn, impact the prices. The higher inflation rate is expected to increase current expenditure because of higher expected inflation, and thus, the price level also increases. As studied by scholars, the monetary policy has the capability to reduce the negative consequences of the pandemic by improving consumption and investment patterns. The current study, therefore, analyses the impact of the federal fund rate on the interest rate and real GDP of an economy during the times of pandemic Covid-19.

Variables and Measures

The study uses the monetary policy premise, as discussed by Taylor ( 17 ) in his study. It explains that the interest rates prevailing in an economy are a result of the real income estimates intruded by the monetary policy refinancing operations. Based on the analysis conducted by Taylor ( 17 ) in his paper “ Discretion vs. policy rules in practice ,” the current study aims to find the relationship between federal funds rate and macroeconomic variables such as inflation rate and real GDP using a predefined equation model. The study has been conducted in the context of UK, China, Brazil, India, and lastly Japan's monetary policy determining the inflation rate to curb the negative impact of the pandemic and boost aggregate demand and consumption through inflation rate moderation. The data period under study ranges from the fourth quarter of 2019 (beginning of the pandemic Covid-19) to the third quarter of the year 2020 (current period). The variables under study are as follows:

1. Real GDP (deviation from the target)

2. Federal Funds Rate in percentage

3. The inflation rate over the past four quarters.

The Taylor's Rule applied in the Taylor ( 17 ) study can be reiterated using a model equation as presented below:

P denotes inflation rate, computed using the average Consumer Price Index (CPI) for the past 4 months;

Y represents the real GDP which is the per cent deviation from the target GDP set by the policymakers or monetary authorities.

Although the size of the coefficients can vary because of lack of consensus, the current study uses a representative policy rule of the countries under consideration. The rule states that the federal fund rate increases in case the inflation rate rise above the 2% target or the real GDP increases above the trend GDP. The federal fund rate would be twice if the inflation rate and real GDP matches the target.

The analysis would present the descriptive statistics for the above-discussed variables as well as to conduct a trend analysis of how these macroeconomic variables have changed over the past four quarters due to the occurrence of the pandemic.

Regression Model

The empirical model used Taylor's model to examine the relationship between the federal funds rate and the macroeconomic variables such as real GDP and inflation rates in the context of the United Kingdom, Japan, Brazil, China, and India. The figures of the past 20 years have been considered as they would reflect the pandemic situation and impact of monetary policies of the government in controlling the pandemic situation. The study uses a quantitative model, and the data has been collected through reliable secondary sources. The secondary sources used for data collection are FRED Economic Research database which has reliable data for the past 20 years ( 18 ). It is a digital library with a compilation of data related to economic and financial factors, and public access is available for a million data points. The reliability of the data source comes from its publication by the Federal Reserve Bank of St. Lois Review.

The model equation used in this context has been presented as follows.

The equation represents the federal funds rate as a function of the macroeconomic variables (real GDP and the inflation rate). The analysis process would start off with the assessment of the factors affecting the monetary policy interest rates in the real-world scenario. Starting off with Taylor's monetary policy rule formula for computing the federal funds rate, we take a standpoint for examining the nature and direction of the factors that a make up the policy interest rates. This has been undertaken with the help of estimating a series of regression models for the five countries under consideration. The data has been analyzed using Microsoft Excel, and the results of the same have been presented in the following section.

Event Study Methodology

To examine the impact of WHO announcing the Covid-19 pandemic on the monetary interest rates and the real GDP using the event study methodology. This particular methodology has been used in a large number of studies to decipher the impact of the announcement of an event on the value of a firm or for a policy interpretation ( 15 , 19 ). Making use of the event study methodology is that it encapsulates the short-term impact of a given economic/ financial or even business events. In the current scenario, the event study analysis has allowed us to assess the monetary policy impact caused by the coronavirus outbreak as instigated by the changes in the real GDP due to the event.

The Covid-19 pandemic struck the global landscape sometime around later November to early December 2019. However, the WHO issued a series of guidelines for the world leaders regarding the safeguards against the spread of the coronavirus pandemic on 10 January 2020, which has been taken as a guideline for the event declaration ( 20 ). The impact of the global pandemic can be seen through a slump in the economic activity worldwide through the nationwide shutdowns enforced by the governments and the policymakers ( 21 ). This, in turn, has presented a decrease in the aggregate demand and aggregate output in the economy and thereby a slump in the real GDP in various parts of the world. The impact of the pandemic outbreak, as seen on the macroeconomic indicators like the output levels in the economy has also been mitigated by the policymakers through changes made in the monetary policy response packages. This has been examined through event study analysis for the impact of the Covid-19 event on the economies of the United Kingdom, Japan, China, India and lastly, Brazil (as shown in Figures 2 – 6 ).

Figure 2 . Abnormal changes in policy interest rates over the event window: United Kingdom.

Figure 3 . Abnormal changes in policy interest rates over the event window: Japan.

Figure 4 . Abnormal changes in policy interest rates over the event window: India.

Figure 5 . Abnormal changes in policy interest rates over the event window: Brazil.

Figure 6 . Abnormal changes in policy interest rates over the event window: China.

The estimation and time window can thus be illustrated as;

Here, as can be seen, the estimation window has been constructed for 236 months ranging from 01 January 2000 till 01 August 2019, comprising of 236 months in Figure 7 . The estimates have been developed as a monthly change in the value of the policy interest rates in the current period over the preceding time period.

Where, V1 is the value of the estimate in the current time period, and V0 is the value in the preceding time period while V represents the value estimated as a monthly change in the values observed for the policy interest rates and real GDP.

Figure 7 . Event window.

The event study methodology empirically entails the assessment of the abnormal changes (increase or decrease) of performance variables upon the announcement of a particular event. The abnormal changes in the policy interest rates have been estimated every month of the event window ranging from September 2019 till May 2020 has been estimated as;

AC i,t represents the abnormal changes in the policy interest rate “i“ in the month “t;”

OC i,t represents the observed changes in the policy interest rate “i” in the month “t,” over the length of the event window;

And TC i,t represents the theoretical changes in the policy interest rate “i“ in the month “t,” over the length of the estimation window.

The theoretical variations in the policy interest rates of each of the countries have been estimated as a consequence of the regression equation comprising of the policy interest rate as the dependent variable and the real GDP as the independent variable.

Deriving a slope and the intercept values for the real GDP and the interest rates allows us to draw a theoretical value for the changes in the interest rates as instigated by the changes in the real GDP in the economy. Once the observed changes and theoretical changes in the policy interest rates have been categorized, we move on to the assessment of the observed abnormalities in the policy interests in the countries under consideration. This has been undertaken with the help of the application of a cross-sectional Student's t -test. The estimation formula used for the same has been presented below;

Where in the cumulative abnormal changes refer to the abnormal changes in the policy interest rates for every month passed in the event window. The formula can also be presented as;

Where N is the length of the event window. Next, the standard error of the theoretical changes has been estimated using the STEYX function of the excel and can be theorized by the following formula;

Where in, Yi represents the values for Observed Changes and Yi' represents the predicted values or the theoretical changes in the policy interest rates. The estimated values for the t -test have then been used to examine the statistical significance of the abnormal changes observed in the policy interest rates in the case of each of the five countries being examined.

Empirical Results

Regression estimates.

Starting with the assessment of the impact of the irregularity represented by the spread of the Covid-19 pandemic on the economies all across the world, and in order to deliver robust results for the assimilated data, we conduct a regression analysis in order to examine the factors affect the policy interest rates in an economy. Drawing inspiration from Taylor's Rule, we conduct a regression analysis with the policy interest rates as a dependent variable and real GDP and inflation as the independent variables. For each of the countries, the following regression equation has been computed;

The exchange rate is the policy interest rate

CPI is the consumer price index

Real GDP, as acquired from the open access sources reflects on the index of real GDP I country i

ε is the residual noise

α is the intercept.

The results of the regression analysis conducted have been summarized in Table 1 .

Table 1 . Regression model.

The results from Table 1 indicate that both the regressor have a statistically significant impact over determining the policy interest rates in each of the countries under consideration, United Kingdom, Japan, Brazil, China, and India. However, the nature and direction of the relationship between the independent and dependent variable varied in each of the cases. In the case of the UK, while the real GDP index had a positive relationship with the policy interest rate, CPI had a negative relationship with the interest rates in the economy. This, however, is in line with the theoretical implications of the monetary policy theory, that inflation (represented by the consumer price index in the economy) has an inverse relationship with the interest rates and real GDP has a direct relationship with the interest rates ( 22 ). Similar results were reported in the case of the Chinese economy wherein the CPI had an inverse relationship with the interest rates and real GDP had a positive relationship with the dependent variable. In the case of the Japanese economy, both CPI and real GDP had a positive impact on interest rates. On the other hand, in the case of the Indian economy, real GDP had a negative impact over the interest rates while CPI had a positive impact on the interest rates, which contrasts the inference of the model presented in the case of the UK. Lastly, in the case of the Brazilian economy, it was observed that both CPI and real GDP had an inverse relationship with the policy interest rates observed.

Overall, the findings from the regression models constructed for the five economies under consideration present sufficient support for the explanatory variables, i.e., CPI and real GDP having a significant impact over the policy interest rates, as being helpful while determining the future trends of the interest rates for the economies. This comes in especially helpful in examining the impact of the Covid-19 pandemic on the real GDP in the economy and the resultant impact on the policy interest rates ( 23 – 25 ).

Event Study Results

The results of the event study analysis carried out for United Kingdom, Japan, Brazil, India, and China over the length of the given estimation window have been summarized in Table 2 (for UK, Brazil, and Japan) and Table 3 (for India and China). The assessment of the abnormal changes in the interest rates, egged against the cumulative interest rates reflects on a significant downward movement for both the estimates for the United Kingdom, Japan, and India. This can be explained by a constant deterioration in the observed values of interest rates by the British and Indian policymakers as a response to the Covid-19 outbreak. Also affecting the estimates are the deteriorating real GDP estimates for each of the economies in the first 3 months of 2020, which was a direct consequence of the widespread government-imposed nationwide shutdowns. Peculiar observations can be seen in the case of the policy interest rates abnormalities in the case of China, wherein, despite being the worst hit epicentre of the coronavirus outbreak, the policymakers did not resort to monetary relaxations, and no particular changes were observed in the policy interest rates. However, the Chinese economy did suffer considerably, owing to the limited production activities underway due to the shutdowns.

Table 2 . Estimation window: the United Kingdom, Brazil, and Japan.

Table 3 . Estimation window: China and India.

In the case of the United Kingdom, based on the t -test for the abnormal changes, the abnormal changes in the interest rates were statistically significant after the event announcement in the post event window. And thus, it can be considered that the policy interest rates in the United Kingdom were significantly impacted by the changes in the values for Real GDP as triggered by the Covid-19 pandemic outbreak.

In the case of Japan, the abnormal changes in the policy interest rates came out to be statistically insignificant in a larger part of the estimation window, which can be explained by the lack of observed changes in the policy interest rates in the country.

In the case of the Indian economy, the t -test of the abnormal changes was found to be statistically insignificant which presented that the abnormal changes in the policy interest rates in the economy were not impacted by the changes in the real GDP as triggered by the outbreak of the Covid-19 global pandemic.

In the specific case for the Brazilian economy, it is evident from the student's T -test results that the changes in the policy interest rates were unaffected by the changes in the real GDP or by the announcement of the coronavirus outbreak by the World Health Organization.

The Chinese economy, as can be seen from the results of the t -test of abnormal changes, reflected statistically significant results. This allows us to decipher that a lack of variation in policy interest rates, as ought to be theoretically triggered by the changes in the real GDP, caused an abnormal pattern to arise in the policy interest rates in the current scenario. This abnormality can, however, be explained by the controlled economic structure in China, a notion which is evident in the constant policy rates exercised by the monetary authorities in the economy.

The results of the event study analysis can be simplified by describing a basic macroeconomic scenario which involves the announcement of a global pandemic which is likely to affect the existing labor pool and the productive capacity of the economy in the short-run. The impact of the outbreak being such that the production in the country slows down considerably, and the demand side of the economy is impacted by the limitations put in place by the policymakers. This scenario would lead to a deterioration of the real GDP of an economy in the months just after the announcement is made and the economy prepares to shut down. Subsequently, economies revoked the economic shutdowns, and the economy opens up. However, the government lowers the interest rates to propel the productive capacity and bring back the economy from its economic slump. This scenario describes the current market scenario rather closely, and the lowering of the policy interest rates by the major world economies presents itself as a piece of evidence for the monetary expansion sought by the governments worldwide. In summary, this study compares with the significance of the policy interest rate affected by real GDP among above five countries, we find that there is a significant difference between the change of policy interest rate and real GDP in the United Kingdom and China, however, the effect of real GDP of Japan, India, and Brazil on the change of policy interest rate is not significant. As the representatives of emerging market countries, such as China, Brazil, and India, the regional identification of policy interest rate is weaker than that of developed economies. The reason is that the policy interest rate system of emerging countries is immature, the degree of marketization is low, and the policy interest rate has not experienced a free and complete evolution process. In particular, since the outbreak of the Covid-19 epidemic, the economic situation of all countries in the world has been affected by the impact of the Covid-19 epidemic. Therefore, governments around the world have adopted more loose monetary policies to release monetary liquidity in order to strengthen the role of economic recovery. This abnormality can, however, be explained by the controlled economic structure in China, a notion which is evident in the constant policy rates exercised by the monetary authorities in the economy. Although the United Kingdom and Japan are both developed countries with a high degree of financial marketization, the main reasons why Japan's real GDP has no significant effect on policy interest rate are the high degree of aging, low labor productivity and the end of the credit boom. After the asset price bubble crisis, Japanese business departments and family departments were deeply in debt, leading to the rapid evolution of their optimization process from profit maximization to debt minimization, resulting in a shrinking demand for loans. Moreover, the life cycle characteristics of residents' asset liability structure tend to weaken the channels of monetary interest rate and credit, but strengthen the channels of wealth effect. Therefore, the effect of monetary policy in the aging economy ultimately depends on the relative importance of each transmission channel ( 26 – 29 ). Therefore, Japan's real GDP has no significant effect on the policy interest rate.

Considering that the theoretical change of a country's policy interest rate is always affected by some factors, such as fiscal policy, monetary policy, balance of payments, inflation, and so on. It is difficult to select one of these indicators to directly replace the theoretical change of policy interest rate. Therefore, this study follows the research method of Baker et al. ( 30 ) and uses the ”principal component analysis“ method to construct the policy interest rate index to reflect the theoretical change of policy interest rate as a whole. In this method, many indexes with certain correlation are recombined into a new group of comprehensive indexes by the way of principal component dimension reduction to replace the original indexes. As a result, this study selects industrial added value, net fiscal expenditure, balance of payments, foreign exchange reserves, M2 and unemployment rate as principal component analysis indicators, and constructs the theoretical change of policy interest rate index. Furthermore, this study selects the policy interest rate index instead of the initial theoretical change as the dependent variable to recalculate the above linear regression model. The results are as follows. The robustness test in Table A1 of Appendix results are basically consistent with the above conclusions, and it is proved that the estimation results are robust.

Overall, governments aim to get risk of adverse effects of Coronavirus outbreak on the economy by lowering their policy interest rates. In this period, lowering of the policy interest rates by the major economies is for stimulating the economic development and increasing the price level. This study suggests the changes in the monetary policy, as instigated by the unprecedented natural or even man-made events, are rather sporadic and cannot be expected to perform against the theoretical models constructed based on the historical observations of the macroeconomic variables like inflation and output.

The monetary policy allows the policymakers to control the supply of money and credit in the economy. Taking two opposite directions, we have the two forms of monetary policies, expansionary and contractionary. Out of these two, the expansionary monetary policy is sought as a way out for the policymakers to pull the economy from a period of the economic slump through injecting credit into the economy and promoting economic growth within the economy. As the economies run along the course of business cycles, depression, and recovery is a part of their cyclical economic fluctuations, reducing and increasing policy interest rate relative to the changes in the real GDP and inflation is rather common. However, the cyclical fluctuations in the business cycles can be led astray by the occurrence of unprecedented events and/or natural disasters which affect the productive capacity of the economy in short-run, along with having long-run repercussions. One such event which surfaced on the world economic landscape was the outbreak of the coronavirus, in January 2020, as declared by the World Health Organization. The virus outbreak soon gained momentum and evolved into a global pandemic, which sent the policymakers into a flurry of safety procedures and several stringent measures were imposed including national lockdowns as well as travel restrictions and public curfews. The series of events that followed had a detrimental impact on the production and consumption levels in the economies worldwide. This event can be seen as a trigger for changes being made in the monetary policies worldwide to ensure that the productive capacity of the economies is not majorly affected and the economy does not fall to the abyss of economic recession.

This article examined five major economies of the world, United Kingdom, Japan, Brazil, Chin and lastly, India, for the changes in the monetary policy decisions that have been implemented following the Covid-19 outbreak. The assessment was undertaken in the form of an event study analysis, further substantiated with a regression analysis conducted for testing the significance of CPI and real GDP in predicting the policy interest rates in the economy. The results of the regression analysis produced significant results in each of the five economies, which then paved the way for the event study method to be implemented. The WHO issued a series of instructions to the world leaders against a possible virus outbreak originating from China on 10 January 2020, which served as the core event being examined and thereby allowing us to draw up an event window of 9 months ranging from 19 September till 20 May. The estimation window was framed over 20 years, spanning from January 2000 till May 2020. The impact was sought in the form of changes in the policy interest rates, relative to the changes observed in the real GDP as triggered by the announcement of the event. The results of the event study analysis presented that the abnormal changes in the interest rates were statistically significant in the case of the United Kingdom, Brazil, and China, while the abnormal changes were found to be statistically insignificant in the case of India and Japan. This leads to infer the abnormalities in the patterns of changes observed in the policy interest rates in these economies was not substantiated by the changes in the real GDP. In certain cases, the changes made in the interest rates were negligible, as was the case of China and Japan and in other cases the changes made to counteract the economic impact of the Covid-19 outbreak were sporadic. This presents us with the conclusion that the changes in the monetary policy, as instigated by the unprecedented natural or even manmade events, are rather sporadic and cannot be expected to perform against the theoretical models constructed based on the historical observations of the macroeconomic variables like inflation and output.

Further examining the long-standing economic impact of the Covid-19 crisis on the world economies cannot be yet fully examined as the event is still afresh and the event window is rather small and the post-event window being absent. It would be interesting to examine the state of the monetary policy changes, as triggered by the changes in the rates of inflation and real GDP, as triggered by the global pandemic by the end of 2020.

Data Availability Statement

The original contributions presented in the study are included in the article/supplementary material, further inquiries can be directed to the corresponding author.

Author Contributions

YL: writing, discussion, and analysis. YS: data analysis, writing, and supervision. MC: writing and data collection. All authors: contributed to the article and approved the submitted version.

Conflict of Interest

The authors declare that the research was conducted in the absence of any commercial or financial relationships that could be construed as a potential conflict of interest.

Acknowledgments

The authors acknowledge the financial supports from the Philosophy & Social Science Fund of Tianjin City, China (TJYY17-016).

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19. Duso T, Gugler K, Yurtoglu B. Is the event study methodology useful for merger analysis? A comparison of stock market and accounting data. Int Rev Law Econ. (2010) 30:186–92. doi: 10.1016/j.irle.2010.02.001

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22. Lee KS, Werner RA. Reconsidering monetary policy: an empirical examination of the relationship between interest rates and nominal GDP growth in the US, UK, Germany and Japan. Ecol Econ. (2018) 146:26–34. doi: 10.1016/j.ecolecon.2017.08.013

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Table A1 . Robustness check.

Keywords: COVID-19 outbreak, monetary policy, event-study analysis, CPI, real GDP

Citation: Li Y, Sun Y and Chen M (2021) An Evaluation of the Impact of Monetary Easing Policies in Times of a Pandemic. Front. Public Health 8:627001. doi: 10.3389/fpubh.2020.627001

Received: 07 November 2020; Accepted: 14 December 2020; Published: 14 January 2021.

Reviewed by:

Copyright © 2021 Li, Sun and Chen. This is an open-access article distributed under the terms of the Creative Commons Attribution License (CC BY) . The use, distribution or reproduction in other forums is permitted, provided the original author(s) and the copyright owner(s) are credited and that the original publication in this journal is cited, in accordance with accepted academic practice. No use, distribution or reproduction is permitted which does not comply with these terms.

*Correspondence: Yunpeng Sun, tjwade3@126.com

This article is part of the Research Topic

Economic Effects of COVID-19 Related Uncertainty Shocks

Monetary Policy and Innovation

Milton Friedman’s influential 1968 address to the American Economic Association concerning the significance of monetary policy for economic stability highlighted the idea that monetary policy can have real effects in the short run, but not in the long run. In this paper, prepared for the Federal Reserve Bank of Kansas City’s Jackson Hole Economic Symposium, the authors consider one possibility of departing from the neutrality of monetary policy, at least in the medium term, through the effects of monetary policy on innovation. It’s possible, for instance, that monetary policy contractions (such as interest rate hikes) could decrease funding for innovation, causing lasting effects on both innovation and growth. To date, research on monetary policy and innovation is largely theoretical, and empirical analyses on this issue are quite sparse. This paper aims to fill this gap.

To study this issue, the authors use several measures of innovation (e.g., R&D spending, patenting, innovation indices from previous research), as well as macroeconomic indicators such as GDP and unemployment, along with information on historical monetary policy changes. (The authors focus on the effects of conventional monetary policy, or adjusting interest rates, rather than unconventional monetary policy, such as quantitative easing.) They use these data to estimate the effects of monetary policy shocks on innovation activities.

The authors observe the following changes in innovation activities in the years following monetary policy shocks, which they normalize so that each change corresponds to the impact of monetary tightening of 1 percentage point:

• Investment in intellectual property products in the national accounts, which includes aggregate spending on research and development and software, declines by about 1%. Venture capital investment also declines by as much as 25% 1-3 years after a monetary policy shock.
• Patenting in “important technologies,” defined as innovations that became major topics in earnings discussions, declines by up to 9% 2-4 years after a shock. Interestingly, patenting in other technologies declines by less.
• The overall economic value of patents, which is based on aggregating stock market reactions to the approval of individual patents, also declines by up to 9% in the years following a monetary policy shock. This drop can contribute to declines of 1% in real output and 0.5% in total factor productivity after five years.

What explains these results? The authors draw on their data to offer the following two explanations for how monetary policy shocks impact innovation:

• Monetary policy can influence innovation by changing aggregate demand and correspondingly the profitability of innovation. Industries where demand is more closely tied to economic conditions are more. responsive to monetary policy shocks. Their spending on research and development also changes by more in response to a shock. In addition, the change in innovation activities occurs among both public and private firms, and among both large public and small public firms. To the extent that large public firms are less affected by financial conditions, the change in technological development among these companies is likely driven by demand, not just financial market conditions.
• Monetary policy can also influence innovation by changing financial market conditions. Early-stage venture capital investment declines after monetary policy tightening. To the extent that early-stage startups are still in the product development phase and may not have products coming to the market immediately, the reduction of funding could reflect less appetite among investors for risky undertaking, not just reduced demand.

These findings suggest that monetary policy may affect the productive capacity of the economy in the longer term, in addition to the well-recognized near-term effects on economic outcomes. Developments in the past several years highlight the relevance of these issues. Rising interest rates since 2022 have been accompanied by a substantial decline in venture capital investment. Meanwhile, recent breakthroughs in artificial intelligence raise the hope that another technological revolution could be on the horizon. While the authors’ focus is to present empirical facts and optimal policy analysis is beyond the scope of this paper, they encourage further research on this dimension of monetary policy.

More on this topic

Monetary Policy and the Labor Market: A Quasi-Experiment in Sweden

Households’ Response to the Wealth Effects of Inflation

The Long-term Effects of Inflation on Inflation Expectations

List of Research Papers Related to Monetary Policy

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Introduction Aggregate demand and interest rates, along with the actual economic growth and the prospects are the benchmarks of any Federal government. In order to control the economy, government uses monetary policies to analyze essential measures.

Open Market Operation

Open Market Operations involve purchase and selling of governmental securities which helps to stabilize inflation. The Federal funds rate is equal to the interest and lending rates, according to which financial institutions charge for the loans. The Domestic Open Market Operations are guided by the Federal Open Market Committee and continuing with the aid of strengthening the efforts to support economy recovery path in a price-stabilizing context, while providing extra policy recommendations . Adjustment of the amount and structure of the Federal Reserve Balance Sheet is done to counter the pressure, especially on long-term interest rates.

Lending rate

Discount rate is the amount of money banks are charged for when loaning cash from Central Bank. Federal Reserve Bank has the mandate to change the rating to discourage/encourage banks and other financial institutions from borrowing/to borrow money. A change in the lending rate has a huge impact on the amount of money circulating in the economy. This mechanism usually describes the intentions and plans of Federal Bank towards the their monetary policy.

Fractional Reserve Banking

This is a deposit required to be kept in by every financial institution in the Federal Reserve as the minimum value . Federal Reserve gains a certain percent from such a deposit and the rest of the sum is provided for potential borrowers.

Interest Rate

The graph shows how the US economy behaved within 1969-1984 time period. Inflation had started reducing in 1969, and drastically fell to negative 3 in 1973. Money circulation in 1975 was minimal as the country experienced deflation; Federal Reserve Bank imposed a monetary measure to control and increase the money supply to the economy. Economic situation improved and inflation climbed to 3.5 in 1981. The economy improved and went a notch higher to an inflation rate of 3.5 in 1981. In order to regulate the fiscal policy, Reagan attempted to decrease the growth of government spending. But he couldn’t do important changes in this issue since economic growth was somewhat slower than expected. As shown in the figure 1 below between his eras, 1981-1989, there wasn’t any affected decrease in the government spending, While he began in 1981, the government spending was at approximately 22% and it was almost at the same level in his last year 1989.

Federal Government Expenditure

Dramatic changes were made to the top marginal tax rate on individual income by lowering from 70% to 28%. Moreover, the corporate income tax was wilted from 48% to 34%. Most of the poor people were waived off the individual income tax. Interest rate normally changes with economic situation and financial policies of the government; expectations of banks and other financial institutions, and their borrowers on the future price changes. However, before the interest rate is determined, array of factors, including Dollar price is taken into account. Equinox is achieved when financial institutions satisfy the demands of their clients in amounts of money they prefer to lend. Interest level changes with the change of cash quantity supplied vis-à-vis the demand from the borrowers. As seen on chart below USA government debt increased from almost 38% of GDP to almost 60% of GDP after 1981. The government has traditionally depended on the three instruments to perform monetary policy. Firstly, it can alter reserves available in the central reserve. The reserves can be in currency or deposits. These reserves put a threshold on the amounts a financial institution can hold as cash . Secondly, the federal government may take a credit. Yet, the key method is Open Market Operations (OMO), and it involves selling of securities of US Government.

Why Monetary Policy is Important

- It lowers macro financial vulnerabilities. During US economic crunch, prices of commodities went to the ceiling leaving consumers go for the basic commodities a drive that forgotten long ago. Consumptions bundles beyond the borders were cheap as compared to the countries hence paving way importation, which was then cheap. - Enhances Central bank Accountability and autonomy. New laws gives Federation reserve primary role to look at effect price stability and enabling Federal reserve with economical independent and adopts monetary policies as ought to in order to achieve their mandate .Monitory policy gave federation reserve the immune from choosing the monitoring operations fit to teach the institution goals. 3) Enhances monetary policy adoption, having clear responsibility on stabilizing prices, every Central bank adopts Information Technology in improving their operations. IT helps a lot while predicting inflations and give allowance for adjustments for increased monetary policy. Central banks revamp their IT frameworks 4) Cooperates in improving the operational web. Central banks works better in revamping their frameworks .Policy rate is determined when the monetarist sit and decide on the appropriate short-term rate as the working target. Monetarist helps in settling on a particular rate whether policy rate or Market-based overnight interest rate . In order to attain short-term rates to policy interest rate, Federal bank normally conducts open market rates nearly to policy rate. Monetarist in Federal Reserve majorly depends on forecasting liquidity as a guide to the open market operations. Efficient means have been developed to forecast factors that may lead to liquidity imbalance, which might trigger interest rate deviation from the policy rate. 5) Helps coping with the surge in commodity and food prices, just before the financial crisis explosion, the monetarist warned of inflation. Inflationary pressures showed a combined rising of both domestic demand and accosts. With the cost-push analysis, Central banks help in harmonizing rising food and oil prices. Energy and other commodity prices had been on the rise in the world market. For instance, the various strategies that the U.S. Federal Reserve adopted to cope with the financial crisis that stuck the U.S. in the year 2009 were far more different to those that were adopted during the 2008 crisis.

During 2008, the Federal Reserve implemented a large number of emergency lending measures. The same is indicated in the graph below:

Source: http://www.econbrowser.com/archives/2012/08/us_monetary_pol.html There are a number of individual components which encompassed the above emergency lending of the Fed, like currency swaps, Term auction facility etc. The graph below represents the various individual components of the 2008 emergency lending of the Fed. Source: http://www.econbrowser.com/archives/2012/08/us_monetary_pol.html 6) Manages capital inflow, Federal Reserve controls and made some adjustment on the amount of capital of finances should circulate within a country and the reserve requirement. The Federal Reserve also controls reserve needed on both foreign currency and domestic liabilities and differentiated, with a higher reserve coefficient. Besides raising reserve requirement in local currency, the Federal Reserve Bank imposes unremunerated reserve threshold on foreign borrowing and inflow portfolios. In case of the need of more reserve of local currency, monitory policy chips in and slows down cash growth. 7) Early information. Federal Reserve explains to the market participant on their decisions, policies, and goals to be achieved within a specification of time. The prospect for economic recession and low inflation warranted an aggressive cut of policy rates. Selling foreign exchange by the Federal Reserve is reasons one being to secure liquidity aspects in foreign currency.

The Effect of not implementing a Monetary Policy

Long and variable lags, actions leveled to stimulate an economy would destabilize it. Because of the involvement of the e lags, the difficulty of predicting the effects of such activities would not allow any kind of action being taken in advance which might be correct when its effect occurred. The historical time series for money growth and cyclical turning points showing that currency lead turning points in the economy and that the timing of the connection was variable. Such reactions functions would cause Federal Reserve Bank to change the settings of their policy instrument without regard to the lags involved. Given so many lags monitory policies if not used well, will accumulates several mistakes . While the stock of cash directly related to commodities price level on average, there is much variation in the relation over a short period. Monetary changes have their effect only after a considerable lag and over a long period and that, lags are rather variable while price level could be an effective guide only if it were possible to predict, first effects of non-monetary factors on the price level for a considerable period in the future. Federal Reserve Bank uses the interest rate is the only instrument used. This interference serves as a tool for setting rate targets in such a way that the setting is analogous to price fixing. The nominal interest rate is the price of Dollar today in terms of dollar tomorrow. Because individual welfare is reliant upon factors like the real variables, market forces fail to reduce this price determinate. The central bank must provide nominal determinacy in way that it controls the actual and expected future creation of money. Federal reserve bank focus exclusively on regulating financial intermediation to the exclusion of money lack a rule that provides a stable nominal anchor. Virtually, without the presence of a nominal anchor in the form of constancy in projected inflation changes by the central banks to its rate target do not interpret into anticipated changes in the real interest rate. Although lenders and borrowers contract in terms of the nominal interest rate, their inflation forecast interprets the nominal rate into a real rate. Central bank interferes with the market determination of this real interest rate constitutes price fixing. An example, as consequences of maintaining a rate that is too high, the central Bank must sell bonds and existing money in order to offset the resulting excess demand in the bond market. During financial stress, funds flow from illiquid debts instruments into the demand the signal to noise ratio is very low for monitory aggregates . Nothing in fact, however, bears on the validity of the monetarist hypothesis that monetary control and a rule that follows the price system to work are inseparable concepts. The attempt by the central banks to engineer a negative output gap in order to reduce either the prices of the asset or inflation can be an essential circumstance for recession without also being a sufficient condition. The central banks may operate regularly with an activist rule in which it manipulates Philips curve trade-offs but periodically is unlucky. The monitories hypothesis, however is that in order to evade the economy from destabilizing, the central bank should follow a non-activist rule.

Artificial Economy

Its main feature includes an open economy where optimal behavior of consumers leads to equilibrium transition paths of endogenously determined variables. Some of these variables, for instance the aggregate, supply the economy, behave in a forward manner that takes into consideration staggered pricing mechanism. It also generates inflation inertia and recessionary disinflation in the economy that allow the monetary policy interventions as well as the exogenous stochastic process. This will produce equilibrium and results to real effects in the short run.

On Household

There is a continuum of household making sequence of decisions during each period. It makes its consumptions decisions and its capital accumulations decisions and decides on how many units of capital services to supply . The ability to purchase securities whose payoff is contingent upon whether it can re-optimize or not. Household finally decides how much of its financial asset to hold with a financial intermediary in the form of deposits and how much to hold in the form of liquid cash. Since the uncertainty faced by the household over whether it can re-optimize its wages is idiosyncratic in nature, household work different amounts and earn different wage rate. Loan Market Clearing and the resource constraint, Household absorbs an increase in the money supply, this is because the demand for money supplied. As in standard limited participation model, the drop in interest rate because of the subset of agents must absorb the full amount of an increase in the money supply. Unlike those models, here household absorb the cash. The decline in the interest rate reduces marginal cost. This in turn helps the model generate an inertia response of inflation to appositive monetary policy shock.

Natural Disasters

In August 2005, US was hit by Katrina which caused unprecedented damage to property worth an estimate $150 billion making it a disaster of its kind. As a result, economy’s activities are disrupted immediately after the wrath . Domestic production fell by 0.4 percent margin in the third quarter of 2005. The degree of disaster caused Federal Open Market Committee to postpone 25% increase in federal funds rate.

Natural disasters may destroy an economic, effecting productive capital stock, disaster production, which we model as transitory negative technology shock.

Considering two crucial characteristics of a natural disaster like a Hurricane and Katrina. Disaster destroys an economic all relevant share of the economy‘s productive capital stock, disaster too disrupts temporarily production, which we model as transitory negative technology shock. Since natural disaster is an infrequent event, the disaster shock model as two –state marks of switching process. The negative shocks to the capital stock and to technologically specified S functions of the two –state disaster variable. To compensate for lost productivity and a lower capital stock, then on-price adjustment firms must upsurge their labor to maintain the levels of production. Conversely, Price–adjustments firms reduce their labor demand as output falls. As a result, employment increases in the sticky price model and sticky prices and wage, but decreases in the flexible model

Conclusions

Monitory policies meant to controls the amount of money on the hands of the public. The policies formulated and implemented by Federal Reserve; the Federal Reserve banks oblige the forces of supply and demand by raising and lowering interest rates as per the Federal Reserve requirements . Federal Reserve has three major mechanism of controlling and manipulate sing amount of cash in the public hands. The federal can buy and sell securities, which will increase cash circulation, and the reverse is true, using open market operation helps in a short period interests rates and the federal cash rate, dictates the interbank lending rate and the lending rate by the Federal Reserve Bank.

Econbrowser. (2012, August 26). U.S. monetary policy since the financial crisis. Retrieved November 27, 2013, from Econbrowser: http://www.econbrowser.com/archives/2012/08/us_monetary_pol.html John.S, C. K. (2012). Innocent Bystanders: Monetary Policy and Inequality in the U.S. (EPUB) . Andrew Mc Meel Publishing. N'Diaye, P. M. (2009). Macroeconomic Implications for Hong Kong Sar of Accommodative U.S Monetary Policy. International Monetary Fund. Niskanen, W. A. (1988). Reaganomics. Retrieved November 27, 2013, from Library of Economics and Liberty: http://www.econlib.org/library/Enc1/Reaganomics.html

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