# What is the difference between monetary policy and monetary policy shock

Sorry for a silly question but I must know the answer to the question.

I am asking this because it seems like some people do not

differentiate between monetary policy and monetary policy shock.

For example, in Smets and Wouters (2003)

"Third, we analyze the effects (and the uncertainty surrounding those effects) of the various structural shocks (which includes monetary policy shock) on the euro area...a temporary monetary policy tightening, associated with a temporary increase in the nominal and real interest rate, has a hump-shaped negative effect on both output and inflation as in Peersman and Smets (2001)."

To summarize their paragraph, they looked at the effects of positive monetary policy shock on economy and treating those effects as effects of a temporary monetary policy tightening (or monetary policy tightening) on economy.

Monetary policy are all the endogenous actions of the central bank in response to economic conditions. Monetary policy shocks are all the unanticipated actions the central bank takes. To make this more concrete, think of the macroeconomic variables as evolving according to a SVAR:

$$A_0 X_t = B_1 X_{t-1} + \dots + B_N X_{t-N} + \epsilon_t.$$

where $$X_t$$ is the vector of relevant (will not unpack this here) macroeconomic variables at time $$t$$ and $$\epsilon_t$$ are random variables, the structural shocks. Suppose that the only relavant tool for the central bank is the interest rate, $$i_t$$, so that $$X_t = \begin{bmatrix} i_t \\ \tilde{X_t} \end{bmatrix}$$ and $$\epsilon_t = \begin{bmatrix} \epsilon_{i,t} \\ \epsilon_{\tilde{X_t},t} \ \end{bmatrix}.$$ Notice that for any sequence $$\{X_k\}_{k=t-N}^{t-1}$$, in the absence of structural shocks, we would be able to predict $$\{X_t\}$$, and in particular the actions of the central bank, i.e., the $$i_t$$ it would set - this is monetary policy. On the other hand, by design, we would not be able to predict the values of $$\epsilon_t$$ since it is a random vector. In particular, we cannot predict with 100% certainty $$\epsilon_{i,t}$$ - the monetary policy shocks.

• This was helpful. Thank you.
– EHMJ
Jun 25, 2023 at 2:01
• Sorry 1 last question. Given the assumption that central bank's only relevant tool is the interest rate, is monetary policy a sequence of the interest rate?
– EHMJ
Jun 25, 2023 at 5:11
• Not sure what you are asking tbh. If you mean Is the announced path of interest rates a monetary policy tool beyond just the contemporaneous target rate?, the answer is definitely yes, If you mean in this specific case is $\{i_{t+k}\}_{k\geq0}$ defined as monetary policy?, yes, with the interpretation given above. Aug 25, 2023 at 15:20
• Sorry for the late response. I understand now. Thank you for your time @RAGMS
– EHMJ
Oct 2, 2023 at 21:30

Monetary policy is just broad term for the policies monetary authorities are pursuing. For example, one could say Fed between 2009 and 2019 was pursuing loose monetary policy (low interest rates, asset purchases, lowering reserve requirements etc). Monetary policy is an umbrella term for policies of monetary authority.

Monetary policy shock is said to occur when monetary policy changes significantly without any sufficient advanced warning. You can consider it 'unexpected' change in monetary policy.