Abstract:
This paper examines the dynamic relationship between changes in the funds rate and nonborrowed
reserves within a reduced form framework that allows the relationship to have two distinct patterns
over time. A regime switching model a la Hamilton (1989) is estimated. On average, CPI inflation
has been significantly higher in the regime characterized by large and volatile changes in funds rate.
Innovations in money growth are associated with a strong anticipated inflation effect in this high
inflation regime, and a moderate liquidity effect in the low inflation regime. Furthermore, an identical
money innovation generates a much bigger increase in the interest rate during a transition period from
the low to high inflation regime than during a steady high inflation period. This accords well with
economic intuition since the transition period is when the anticipated inflation effect initially gets
incorporated into the interest rate. The converse also holds. That is, the liquidity effect becomes
stronger when the economy leaves a high inflation regime period and enters a low inflation regime
period.
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