A model of monetary policy shocks for financial crises and normal conditions

In late 2008, deteriorating economic conditions led the Federal Reserve to lower the federal funds rate to near zero and inject massive liquidity into the financial system through novel facilities. The combination of conventional and unconventional measures complicates the challenging task of characterizing the effects of monetary policy. We develop a novel method of identifying these effects that maintains the classic assumptions that a central bank reacts to output and the price level contemporaneously and may only affect these variables with a lag. A New-Keynesian DSGE model augmented with a representative financial structure motivates our empirical specification. The equilibrium model provides theoretical support for our choice of different series to replace variables that were popular in models of monetary policy but became problematic in the aftermath of the 2008 financial crisis. One of our most important innovations is to utilize the Divisia M4 index of money as the policy indicator variable. The model is bolstered by its ability to produce plausible responses to a monetary policy shock in samples that include or exclude the recent crisis period.