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The reason is that central banks react to variables, such as inflation and the output gap, which are endogenous to monetary policy shocks. Endogeneity implies a correlation between regressors and the error term, and hence, an asymptotic bias. In principle, Instrumental Variables IV estimation can solve this endogeneity problem.
In practice, IV estimation poses challenges as the validity of potential instruments also depends on other economic relationships. We argue in favor of OLS estimation of monetary policy rules. To that end, we show analytically in the three-equation New Keynesian model that the asymptotic OLS bias is proportional to the fraction of the variance of regressors accounted for by monetary policy shocks.
Using Monte Carlo simulation, we then show that this relationship also holds in a quantitative model of the U.
As monetary policy shocks explain only a small fraction of the variance of regressors typically included in monetary policy rules, the endogeneity bias is small. Using simulations, we show that, for realistic sample sizes, the OLS estimator of monetary policy parameters outperforms IV estimators.Preliminary versions of economic research.
The Time-Varying Effect of Monetary Policy on Asset Prices. Pascal Paul • Federal Reserve Bank of San FranciscoEmail: [email protected] First online version: November Engineering was love at first sight for me.
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