IV. THEORETICAL FRAMEWORK
An important question to consider is how many variables are needed to properly capture the effect of policy innovation. Bai and Ng (2002) provided a guide on this however it did not address specifically the number of variables that should be present in the VAR. To explore the effects of policy innovation we will look at 6 variables
We will estimate the model using VAR methodology. Sims (1980) introduced VAR methodology as a method of measuring the effects of monetary policy. The methodology can trace the dynamic response of price, output and other variables resulting from policy innovation by obtaining quantitative estimation of the affects on the economy as it only requires a plausible identification of the shocks.
There is no disagreement on how to estimate VAR, it is given by
is a m×1 vector of data at date t = 1−l, . . . , T,
is coefficient matrices of size m × m,
is the one-step ahead prediction error with variance-covariance matrix
In most literature, the short term interest rate has served as the instrument used to measure monetary policy and has been used for most empirical studies. We will follow this same approach and use it as the policy tool
The ordering of the VAR is (ffr cpi gdp urate m2 sp500) where ffr is the federal funds rate, cpi is the consumer price index , gdp is the real gross domestic product, m2 is the measure of money supply, sp 500 is the equity price index.
V. DATA AND DESCRIPTIVE STATISTICS
Table 1 shows the descriptive statistics for the variables used in this study. The sample consists of observation from the 1st quarter of 1994, to the 4th quarter of 2013. The data are all sampled to the quarterly frequency via averaging of monthly data. All data was retrieved from the Federal Research Economic Data Website.
The Short term interest rate is the effective federal Funds rate as measured by the Fed Board of Governors. The Effective Federal Funds Rate (FFR) is the interest rate that
depository institutions actively trade the balances they hold at the Federal Reserve with each other on a short term basis (usually overnight) without the need for collateral. For the purpose of this research we will use it as the policy tool for innovation. There exist literature that has used Money supply as the policy innovation tool, but we will rely on literature after 2004 and use the FFR.
To proxy inflation we use the CPI for all urban consumers and all items as measured by the Bureau of Labor and Statistics. One of the Feds mandate towards monetary prices is to ensure stability of prices. The CPI examines the weighted average of prices of a basket of consumer goods and services. CPI is one of the most frequently used statistics for identifying periods of inflation or deflation.
GDP is important because nations have equated economic growth with progress of a nation hence it is considered as the standard measure of Economic progress. We will use seasonally adjusted data measured in billions of chained...