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ECONOMIC RESEARCH REPORTS SYSTEMATIC MONETARY POLICY AND THE EFFECTS OF OIL PRICE SHOCKS by Ben S. Bernanke, Mark Gertler, and Mark Watson RR# 97-25 June 1997 C.V. STARR CENTER FOR APPLIED ECONOMICS 2 ! NEW YORK UNIVERSITY FACULTY OF ARTS AND SCIENCE DEPARTMENT OF ECONOMICS WASHINGTON SQUARE NEW YORK, NY 10003-6687 systematic Monetary Policy and the Effects of Oil Price Shocks Ben §. Bernanke Princeton University and NBER Mark Gertler New York University and NBER Mark Watson Princeton University and NBER May 27, 1997 abstract Macroeconomic shocks such as oil price increases induce a systematic (endogenous) response of monetary policy. We develop a VAR-based technique for decomposing the total economic effects of a given exogenous shock into the portion attributable directly to the shock and the part arising from the policy response to the shock. Although the standard errors are large, in our application, we find that a substantial part of the recessionary impact of an oil price shock results from the endogenous tightening of monetary policy rather than from the increase in oil prices per se URL: E3, B5 Presented at the Brookings Panel on Economic Activity, Naxch 27-28, 1997, Washington DC. Thanks to Ben Friedman and Chris Sims for helpful comments, and to Don Redl and Peter Simon for expert research assistance. The financial support of the National Science Foundation and the C.V, Starr Center is gratefully acknowledged The principal objective of this article is to increase our understanding of the role of monetary policy in postwar U.S. busines: cycles. We take as our starting point two conmon findings in the recent vector autoregression (VAR)-based literature on monetary policy (see, e.g., Leeper, Sims, and Zha (1996)): First, identified shocks to monetary policy explain relatively little of the overall variation in output (typically less than twenty per cent). Second, most of the observed movement in the instruments of monetary policy, such as the federal funds rate or nonborrowed reserves, is endogenous; that is, changes in Federal Reserve policy are largely explained by macroeconomic conditions, as we might expect given the Fed’s commitment to macroeconomic stabilization. These two findings obviously do not support the view that erratic and unpredictable fluctuations in Federal Reserve policies are a primary cause of postwar U.S. business cycles; but, on the other hand, neither do they rule out the possibility that systematic and predictable monetary policies---the Fed’s policy rule affect the course of the economy in an important way. Put more positively, if one takes the VAR evidence on monetary policy seriously (as we do), then any case for an important role of monetary policy in the business cycle rests on arguing that the choice of monetary policy rule (the “reaction function”) has significant macroeconomic effects. Using time series evidence to uncover the effects of monetary policy rules on the economy is, however, a daunting task. It is not possible to infer the effects of changes in policy rules fron a standard identified VAR system, since this approach typically provides little or no structural interpretation of the coefficients that make up the lag structure of the model. Large-scale econometric models, such as the MPS model, are designed for analyzing alternative policies; but criticisms of the identifying assumptions of these models have been the subject of a number of important papers, notably Lucas (1976) and Sims (1980).