Monetary Policy is how the Central Bank influences the path it wants the economy to follow. It does this through the control of money supply using the short term interest rate as the primary instrument to control inflation and economic growth.
The objectives of most Central banks is to sustain low unemployment and relatively stable prices however price stability is the main, medium and longer run goal of monetary policy. An expansionary monetary policy is targeted at increasing the money supply through lowering interest rates with the hope of increasing consumption and investment through easing credit; it is used to combat unemployment in periods of recession. A contractionary policy however is used to decrease money supply by increasing the interest rate; it is intended to slow down inflation.
Monetary policy has been an area with lots of economic research in several countries with the focus being on the empirical analysis of monetary policy shock on output and prices. Econometric models have been used to determine the effects of different policy options. With time, econometric analysis techniques have improved and most recent literatures have estimated the effects of monetary policy using VAR and SVAR techniques, this has allowed the evaluation of the effectiveness of monetary policy in several countries.
In the actual, shocks in the economy are driven by developments beyond the central bank. Studies on monetary policy have exhibited a large variance in results amongst different countries primarily resulting from the different business cycles experienced at different times between countries; output and prices appear to be strong or weak depending on sample periods
The objective of this study is to examine the effects of monetary policy on the components of aggregate demand between the periods of 1994q1-2013q4. Following other papers on monetary policy, the paper used VAR model of estimation
II. INSTITUTIONAL BACKGROUND
i. Monetary Policy Framework in the US
The Monetary Policy Framework in the US is implemented by the Federal Reserve System. There are 12 Federal Reserve Banks that are independent in their day-to-day operations but legislatively accountable to Congress through the auspices of 7 Federal Reserve Board of Governors. The Fed is committed by law to engage in policy that pushes for low unemployment, moderate long term interest rates and stable prices.
ii. Monetary Instruments
The Fed fund rate is the traditional tool used in monetary policy. It is the interest rate at which depository institutions actively trade the balances they hold at the federal Reserve with each other on a short term basis (usually overnight).The Fed uses Open Market operations to influence the effective Federal funds rate to follow the Federal Funds Target rate.
Since August 2007, the Federal Reserve has eased monetary policy aggressively in the face of the worst financial crisis that the United States has experienced since the Great