Working Paper Series no. 973. We propose a novel identification design to estimate the effects of systematic monetary policy on the propagation of macroeconomic shocks. The design combines (i) a time-varying measure of systematic monetary policy based on the historical composition of “hawks” and “doves” in the FOMC with (ii) an instrument that leverages the FOMC rotation of voting rights. We apply our design to government spending shocks. We find that a dovish FOMC supports the expansionary effects of higher spending by delaying policy rate hikes, leading to large fiscal multipliers. GDP does not expand when the FOMC is hawkish, but inflation expectations are contained.
Figure 1: Comparing the effects of an expansionary government spending shock under a hawkish and a dovish FOMC
Monetary policy decisions made by central banks are intentional responses to macroeconomic conditions. These responses are known as systematic monetary policy. In theory, systematic monetary policy plays a crucial role in influencing the impact of macroeconomic shocks. However, there is a lack of empirical evidence that identifies and quantifies this causal relationship. In this study, we first introduce an identification design to assess the causal effects of systematic monetary policy on the propagation of macroeconomic shocks. We then use this design to study the interaction between government spending and the response of systematic monetary policy. Our findings show that systematic monetary policy is a crucial determinant of the effectiveness of fiscal policy. Our identification design combines a measure of systematic monetary policy based on the historical composition of “hawks” and “doves” since the 1960s in the Federal Reserve’s Federal Open Market Committee (FOMC), in charge of monetary policy decisions in the US, along with an instrument that levers the mechanical rotation of voting rights in the FOMC.
The classification of FOMC members as “hawks” or “doves” is based on narratives from news archives, portraying them as either more concerned about inflation (“hawks”) or more concerned about supporting employment and growth (“doves”), as in Istrefi (2019). To account for changes in the composition of “hawks” and “doves” in the FOMC that are influenced by economic and political developments, we construct an instrumental variable that takes advantage of the mechanical rotation of voting rights in the FOMC. This rotation is a yearly process that redistributes voting rights among the Federal Reserve Bank presidents. The mechanical nature of the rotation renders it exogenous to economic or political factors, allowing us to identify the causal effects of systematic monetary policy.
Our findings show that the response of GDP to government spending shocks depends crucially on the number of dovish and hawkish FOMC members. An increase in discretionary government spending leads to a GDP expansion, which is more pronounced when more dovish FOMC members vote in the FOMC. Conversely, more “hawks” dampen the expansionary effect of government spending. Quantitatively, we find that the peak GDP increase roughly doubles when there are two more doves in the FOMC relative to the long-run sample average. In contrast, we find that GDP does not expand in response to additional government spending when there are two more “hawks” in the FOMC.
It is important to note that drawing the conclusion that the government should increase spending when central banks have committees with dovish members in the majority could be misleading. This is because such changes in government spending would not be random shocks (what we studied) but predictable policy decisions. The Lucas critique applies if there are structural changes in the conduct of fiscal policy.
Keywords: Systematic Monetary Policy, FOMC, Rotation, Government Spending
JEL classification: E32, E52, E62, E63, H56.
Updated on the 17th of December 2024