Total Factor Productivity and Monetary Policy: Evidence from Conditional Volatility

This paper empirically assesses whether monetary policy and its volatility affect real economic activity through their effect on the aggregate supply side of the macroeconomy. Analysts typically argue that monetary policy either does not affect the real economy (the classical dichotomy) or only affects the real economy in the short run through aggregate demand (new Keynesian or new classical theories). Real business cycle theorists try to explain the business cycle with supply‐side productivity shocks. We provide some preliminary evidence about how monetary policy and its volatility affect the aggregate supply side of the macroeconomy through their effect on total factor productivity and its volatility. Total factor productivity provides an important measure of supply‐side performance. The results show that monetary policy and its volatility exert a positive and statistically significant effect on the supply side of the macroeconomy. Moreover, the findings buttress the importance of reducing short‐run swings in monetary policy variables as well as support the adoption of an optimal money supply rule. Our results also prove consistent with the effective role of monetary policy during the so‐called ‘Great Moderation’ in US gross domestic product volatility beginning in the early 1980s.