The Federal Reserve's response to aggregate demand and aggregate supply shocks: evidence of a partisan political cycle

Southern Economic Journal, Jan, 1997 by Edward N. Gamber, David R. Hakes

The orthodox approach to modeling the Fed's response to economic conditions is to employ a monetary policy reaction function. Most reaction functions are estimated by regressing a policy indicator, possibly the federal funds rate or a monetary aggregate, on variables that describe the state of the economy, such as unemployment, inflation, and growth in output.(1) Under certain conditions which we discuss below, estimated coefficients from a reaction function provide information about the Fed's monetary policy priorities. Moreover, extending the model to include election and partisan dummy variables may provide information about the Fed's response to political pressures.

There are two problems with interpreting the coefficients in a standard reaction function as the weights that the Fed attaches to its policy objectives. First, the monetary policy decision may not be represented accurately by an aggregate reaction function (one that models the Fed as a whole) because there are twelve voting members on the FOMC. Chappell, Havrilesky, and McGregor [10] have recently addressed this issue by employing a "disaggregated" set of reaction functions.

The second problem with interpreting reaction function coefficients as the weights the Fed places on its policy objectives is that this interpretation implicitly assumes structural stability of the underlying macroeconomy. Abrams, Froyen, and Waud [1, 31] acknowledge this shortcoming when they state, ". . . coefficients from estimated reaction functions . . . do not provide direct information on policymaker utility functions. Rather than being the solution to an unconstrained optimization dependent only on policymaker preferences, reaction functions are the output of a constrained maximization, where the constraints are the reduced-form equations that characterize the economy. [Therefore] a finding of instability in policy response would not necessarily indicate that policy formation was subject to political or other pressures." Nearly all studies employing reaction functions, however, avoid this problem by assuming that the structural parameters of the economy are stable over the time period estimated. Recently, for example, Chappell, Havrilesky, and McGregor [10, 185] state, "Under the assumption of a stable macroeconomic structure, estimated reaction function coefficients reveal information about the weight the Fed attaches to the various goal variables."

Empirical evidence, however, does not support the assumption of a stable macroeconomic environment. In particular, evidence suggests that there is a unit root in GDP and thus, deviations from trend are not purely transitory fluctuations driven by aggregate demand.[2] Output fluctuations are, to some extent, a function of permanent aggregate supply shocks. Reaction function studies that assume a stable macroeconomic environment implicitly assume that all deviations from trend are aggregate demand driven.[3] If, indeed, both aggregate demand and aggregate supply shocks are important determinants of economic fluctuations, then prior interpretations of reactions functions may be invalid.

To illustrate the importance of allowing for this type of structural change in the underlying model (i.e., aggregate supply shocks), consider the following case: Suppose the Fed is faced with a decrease in output. If the decrease in output is generated by a negative aggregate demand shock, the accompanying reduction in inflation allows the Fed to initiate an expansion and trade an increase in inflation for an increase in the level of output. If the decrease in output is generated by a negative supply shock, however, the Fed is faced with the dilemma of increasing inflation further to achieve an increase in output or decreasing output further to achieve a reduction in inflation.

The problem with failing to properly identify the source of the shock is most evident in the context of studies of the political business cycle. These studies generally test whether the Fed is pressured to ease monetary policy prior to elections or during Democratic administrations. However, since aggregate demand and aggregate supply shocks may elicit different responses from the Fed, a change in the Fed's response to output may not be due to political pressure but, instead, to a change in the type of shock generating the movement in output. Thus, failure to identify the nature of these shocks may lead to incorrect conclusions about the Fed's response to political pressures.

The purpose of our paper is to identify aggregate demand and aggregate supply shocks using the method developed by Blanchard and Quah [8] and to measure the Fed's response to each of these shocks. In addition, we measure the difference in the Fed's response to these decomposed aggregate shocks over pre- and post-election periods, and during Democratic and Republican administrations. Thus, while Chappell, Havrilesky, and McGregor [10] disaggregate the Fed's policy vote, we disaggregate the Fed's policy objectives.