Fed and ECB reaction functions during quantitative easing: Three phases of monetary policy, both conventional and unconventional

Studying monetary authority response to macroeconomic imbalances using the interest rate as a proxy variable for monetary policy became ineffective after the financial crisis, when central banks exhausted the effective capacity of interest rates by reaching the zero lower bound (ZLB). In an effort to analyse the unconventional response deployed by central banks, we present and estimate a modified reaction function that uses money supply as the operational instrument of monetary policy for the Federal Reserve and the European Central Bank, and we verify its utility as an explanatory instrument for the behaviour of the two monetary authorities. By applying our strategy, it is feasible to identify both monetary policy reaction with regard to the economic situation as well as other possible monetary authority concerns regarding governments’ fiscal behaviour and the evolution of asset markets, regardless of the monetary policy applied at any given time.