Analyzing Monetary Policy Transmission Mechanism Using Factor Augmented Vector Auto Regression

Abstract

This study models the transmission mechanism of monetary policy by employing Factor Augmented VectorAuto Regressive (FAVAR) methodology, introduced by Bernanke et al., (2005). We use large data consisting of economic and financial markets for U.S, Canada and U.K. We find strong evidence that factors have additional information. We find that due to tight monetary policy shock output declines and employment decreases. Short term and 10 year interest rates increase due to contractionary monetary policy in these countries.

Keywords: Monetary policy, FAVAR, Financial variables