Prague Economic Papers 2019, 28(6):709-728 | DOI: 10.18267/j.pep.699

A Factor-Augmented Vector Autoregressive Approach to Analyze the Transmission of Monetary Policy

Zulfiqar Ali Wagan^a,b, Zhang Chen^a, Hakimzadi Wagan^c

^a Hefei University of Technology, School of Management, Hefei, China

^b Education and Literacy Department, Karachi, Pakistan

^c Sindh Agriculture University, Faculty of Social Sciences, Tando Jam, Pakistan

Using the factor-augmented vector autoregressive (FAVAR) model proposed by Bernanke et al. (2005), this study explores the effect of monetary policy on a wide range of macroeconomic and financial variables for the US, Canada and the UK. The study makes use of financial data from 1990 to 2016, comprising 55-70 variables of the three major nations to show (1) that factors come with additional informational capability, which summarizes the performance of key macroeconomic variables and (2) the manner in which these variables are affected by contractionary monetary policies. Our findings confirm that monetary policy tightening results in decrease in industrial production, employment, share prices, housing starts and inflation; however, it leads to increase in the three-month treasury bill rate, long-term interest rates and unemployment. Overall, the impact of standardized monetary tightening is similar across the countries studied. These results from the major economies and the inclusion of larger data sets containing more variables would be relevant for policy theorists and practitioners from other countries.

Keywords: monetary policy, FAVAR, VAR, Bayesian methods

JEL classification: C11, E40, E52

Received: October 2, 2017; Accepted: April 30, 2018; Prepublished online: September 18, 2019; Published: December 21, 2019  Show citation