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

Abstract

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.