The more the merrier? : a factor-augmented VAR analysis of the Norwegian monetary policy transmission mechanism

2017

How does an economy respond when policymakers change interest rates? In this thesis we

seek to answer this question by examining the Norwegian monetary policy transmission

mechanism. Further, we discuss the evolution in macroeconomic thought on the monetary

policy transmission mechanism and present related empirical evidence. In particular, we

use a Factor-augmented Vector Autoregression (FAVAR) approach to examine the policy

instrument effect over the last twenty-five years, where we assess the response of a

contractionary monetary shock on a broad dataset of 102 variables across the Norwegian

economy.

Present-day policymakers monitor a large set of variables in their decision-making. In order

to reduce the omitted-information problem of small-scale vector autoregression (VAR)

models, we combine the VAR methodology with dynamic factor analysis to assess the effect

of a monetary policy shock on the Norwegian economy. Specifically, the FAVAR model

allows us to better capture the dynamics of the economy by being designed to handle a

large information set, thereby minimizing the probability of biased results. Utilizing a rich

dataset of 103 macroeconomic variables, spanning from 1990:M1 to 2016:M9, we add to

the literature by examining and evaluating the transmission mechanism of monetary policy

in Norway.

The results indeed show that the policy effect is strong and significant across a broad set

of variables in the economy. Furthermore, the results are broadly in line with economic

intuition, indicating a dampening effect on real activity following a contractionary monetary

policy. These findings are consistent with the effects found in earlier literature for

the U.S. economy (Bernanke, Boivin, et al., 2005; Stock and Watson, 2005), and provides

valuable insight on the transmission mechanism of monetary policy in Norway.