The Parametric Model Of The Monetary Policy And The Monetary Policy

After nearly a decade of high inflation, a number of important central banks began in 1979 a concreted effort to reign in inflation. The net effect was transition from a global enviroment where inflation seemed a virtually intractable issue to the current era where the major economies of the world enjoy relative price stability. The monetary policy of a country is the process by which the central monetary authority, controls the supply of money in the economy. Through open market operations, the central bank is able to affect the level of money market interest rates. The term structure of interest rates play an important role in determining the effectiveness of monetary policy. The objective of the present paper is to analyse the impact and the influence of the shifts in the monetary policy on the term structure of interest rates. The properties of the term structure in different monetary policy regimes is important to understand. The central bank operates its policy instrument, the Federal Funds rate for instance, to affect longer term interest rates, and thus the spending by interest rate sensitive sectors of the economy, and eventually unemployment and inflation. Therefore, the central bank 's capacity to achieve its policy objectives depends to a large extent on the relationship between the short-term interest rate and long-term rates. Nonetheless, this relationship is not probable to remain constant when there is a structural change in monetary policy. Indeed, according to the study driven by Cohen and Wenninger, published in 1994, empirical evidence has been provided that long-term interest rates have become more sensitive to the movements in monetary policy instrument. In fact, a rise in the central bank rate tends to flatten the yield curve, however, the yield curve spread tends to fall by less than the increase in the central bank rate. Alternatively, in response to an increase in the central bank rate, the long rate tends to increase, but less than the short rate. The extend of the flattening of the yield in response to an increase in the central bank rate appears to be linked particularly to the credibility attached to the central bank move. In order to illustrate the relationship between the immediate instruments of monetary policy and the spead between long- and short term governement interest rates, we will focus on sample of major Europeen economies (The United Kingdon, France, Germany, Italy) in addition to the United States. To perform the analysis, first, a short-term instrument which serves as an indicator of the stance of monetary policy must be detected in each country. Over the oberservation period, exetending from 1973 to early 1995, for each of the five countries studied, the activity of the monetary authorities in these markets provides evidence of their usefulness for present purposes. In adition, research on US monetary policy has found evidence supporting the use of the federal funds rate as an indicator of the policy stance. The empirical results confirm the relationship along the lines described earlier. An unexpected variation in the central bank rate leads to a flattening in the yield curve for domestic governement securities. However, …show more content…
The closed form solution gives rise to a multi-factor affine model of the term structure. Although, the policy parameter can not be directly estimated in the model, the qualitative impact on the reduced form coefficients of a change in value of the policy parameter, can be identified. Thererfore, to the affine model of the term structure, econometric tests for structural changes and parameter instability can be applied. In the framework of Andrews, Tests for Parameter Instability and Structural Change with Unknown Change Point published in 1993, the test is first conducted for the case of an exogenously fixed break-point, which is October 1979, when monetary policy is shifted to a new regime. Indeed there was a structural break in the yield curve, confirmed from the Wald, Lagrange Multiplier and Likelihood Ratio test statistics. Estimates of the key reduced form coefficients in the term structure model are largely consistent with a story of a permanent shift in policy stance toward controlling inflation since 1979. Additionally, the test is carried out for the case of an endogenously determined break-point. The data show that in coincidence with the shift in monetary policy by 1979, the structural break in the yield curve indeed