Home About Latest Browse RSS Advanced Search

Federal Reserve Bank of Kansas City
Research Working Paper
The Optimal Monetary Instrument and the (Mis)Use of Causality Tests
John W. Keating
Andrew Lee Smith

This paper uses a New-Keynesian model with multiple monetary assets to show that if the choice of instrument is based solely on its propensity to predict macroeconomic targets, a central bank may choose an inferior policy instrument. We compare a standard interest rate rule to a k-percent rule for three alternative monetary aggregates determined within our model: the monetary base, the simple sum measure of money, and the Divisia measure. Welfare results are striking. While the interest rate dominates the other two monetary aggregate k-percent rules, the Divisia k-percent rule outperforms the interest rate rule. Next we study the ability of Granger Causality tests – in the context of data generated from our model – to correctly identify welfare improving instruments. All of the policy instruments considered, except for Divisia, Granger Cause both output and prices at extremely high levels of significance. Divisia fails to Granger Cause prices despite the Divisia rule stabilizing inflation better than these alternative policy instruments. The causality results are robust to using a popular version of the Sims Causality test for which we show standard asymptotics remain valid when the variables are integrated, as in our case.

Download https://dx.doi.org/10.18651/RWP2018-11
Cite this item
John W. Keating & Andrew Lee Smith, The Optimal Monetary Instrument and the (Mis)Use of Causality Tests, Federal Reserve Bank of Kansas City, Research Working Paper RWP 18-11, 28 Nov 2018.
More from this series
JEL Classification:
Subject headings:
Keywords: Monetary Policy Instrument; Monetary Aggregates; Granger Causality
For corrections, contact Lu Dayrit ()
Fed-in-Print is the central catalog of publications within the Federal Reserve System. It is managed and hosted by the Economic Research Division, Federal Reserve Bank of St. Louis.

Privacy Legal