The Effect of Monetary Policy Shocks on the Real Economy: A FAVAR Approach

One of the most important policy issues we face today is the impact of monetary policy shocks on the real economy. This issue is of relevance from an economic point of view, but it is also relevant from a political point of view. Also, the shock of oil price is one of the important factors that have affected the world economy since the 1970s. This article examines the effects of monetary policy shocks and oil price shocks on the real economy. I use the factor augmented vector autoregressive (FAVAR) approach and compare the results with the vector auto-regression (VAR) model by using Iran quarterly data for the period 1988: Q2 to 2011: Q3. The results of FAVAR models are consistent with theory and better than VAR models. VAR models show the existence of price and liquidity puzzles while FAVAR models did not provide any evidence of puzzles.