Regime switching in the dynamic relationship between the federal funds rate and innovations in nonborrowed reserves

Chan Guk Huh

No 536, International Finance Discussion Papers from Board of Governors of the Federal Reserve System (U.S.)

Abstract: This paper examines the dynamic relationship between changes in the funds rate and nonborrowed reserves within a reduced form framework that allows the relationship to have two distinct patterns over time. A regime switching model a la Hamilton (1989) is estimated. On average, CPI inflation has been significantly higher in the regime characterized by large and volatile changes in funds rate. Innovations in money growth are associated with a strong anticipated inflation effect in this high inflation regime, and a moderate liquidity effect in the low inflation regime. Furthermore, an identical money innovation generates a much bigger increase in the interest rate during a transition period from the low to high inflation regime than during a steady high inflation period. This accords well with economic intuition since the transition period is when the anticipated inflation effect initially gets incorporated into the interest rate. The converse also holds. That is, the liquidity effect becomes stronger when the economy leaves a high inflation regime period and enters a low inflation regime period.

Keywords: Bank reserves; Federal funds market (United States) (search for similar items in EconPapers)
Date: 1996
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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedgif:536

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