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Wednesday, January 23, 2008

Quasi-Experimental Evidence on the Neutrality of Money

Arindrajit Dube of the Institute for Research on Labor and Employment at UC Berkeley looks at how recession probabilities on Intrade changed immediately following the Fed's announcement of an emergency rate cut:

Market based evidence on the non-neutrality of monetary policy, by Arindrajit Dube: Ahem… we have for the first time used quasi-experimental evidence to estimate the impact of a large (and surprising) reduction in the federal funds rate on the probability of a recession.  Recent financial innovations allow us to use the market for “recession futures” to estimate impact of policy on implied probabilities in an event study framework.  Using hourly trading data from Intrade.com over a 48 hour period, we find that a 0.75 percentage point reduction in the federal funds rate on the morning of January 22 led almost instantaneously to a reduction in the implied probability of recession from 77% to 68%, and to around 70% after 24 hours of the announcement.

Neutrality
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We find the elasticity of recession odds to policy [d(probability of a recession)/ d(percentage point reduction in rate)]  to be between 9.3 and 12. This suggests that at best, a 400 basis point (4 percentage point) reduction in the federal funds rate can hope to reduce the odds of a looming recession by around 50%.  Our identification assumes that this was both unanticipated in terms of timing, and represents a net reduction in the medium term as compared to the forecasted path of the federal funds rate. If the surprise reduction in federal funds rate is partly substituting for a (now foregone) reduction in the future, the true effects of a medium-term reduction may be understated by our estimates. Overall, our results suggest that rational expectations are inconsistent with the theory of monetary policy neutrality.

    Posted by on Wednesday, January 23, 2008 at 04:12 PM in Economics, Financial System, Monetary Policy | Permalink  TrackBack (1)  Comments (19)

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    » Betting on recession from Econbrowser

    There was also some interesting action on the Intrade betting exchange this week. [Read More]

    Tracked on Thursday, January 24, 2008 at 10:13 AM


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