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The Taylor principle, interest rate smoothing and Fed policy in the 1970s and 1980s

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  • Yash P. Mehra
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    Abstract

    Using real time estimates of output gaps or Greenbook forecasts of the unemployment rate, this article estimates Taylor-type policy rules that predict the actual behavior of the funds rate during two sample periods, 1968Q1 to 1979Q2 and 1979Q3 to 1994Q4. The inflation rate response coefficient is close to unity over the first sub-period and well above unity over the second, suggesting Fed policy violated the Taylor principle during the first period. The adjustment of the funds rate in response to fundamentals is not as rapid during the first period as it is during the second. Together these results support the conventional view that the Fed was "too timid" and "too sluggish" during the late 1960s and the 1970s. Though the Fed smoothes interest rates, the degree of smoothing exhibited is far less than what was previously estimated. The funds rate response to its fundamentals is complete within one year during the first period and within one quarter during the second.

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    Bibliographic Info

    Paper provided by Federal Reserve Bank of Richmond in its series Working Paper with number 02-03.

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    Date of creation: 2002
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    Handle: RePEc:fip:fedrwp:02-03

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    Keywords: Interest rates ; Monetary policy;

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    1. Kevin J. Lansing, 2000. "Learning about a shift in trend output: implications for monetary policy and inflation," Proceedings, Federal Reserve Bank of San Francisco.
    2. Dean Croushore & Tom Stark, 1999. "A real-time data set for macroeconomists," Working Papers 99-4, Federal Reserve Bank of Philadelphia.
    3. Richard Clarida & Jordi Galí & Mark Gertler, 2000. "Monetary Policy Rules And Macroeconomic Stability: Evidence And Some Theory," The Quarterly Journal of Economics, MIT Press, vol. 115(1), pages 147-180, February.
    4. Bennett T. McCallum, 2001. "Monetary policy analysis in models without money," Review, Federal Reserve Bank of St. Louis, issue Jul, pages 145-164.
    5. Orphanides, Athanasios, 2000. "The quest for prosperity without inflation," Working Paper Series 0015, European Central Bank.
    6. Mehra, Yash P., 2001. "The bond rate and estimated monetary policy rules," Journal of Economics and Business, Elsevier, vol. 53(4), pages 345-358.
    7. Rudebusch, Glenn D., 2002. "Term structure evidence on interest rate smoothing and monetary policy inertia," Journal of Monetary Economics, Elsevier, vol. 49(6), pages 1161-1187, September.
    8. Michael Woodford, 2001. "The Taylor Rule and Optimal Monetary Policy," American Economic Review, American Economic Association, vol. 91(2), pages 232-237, May.
    9. Athanasios Orphanides, 2002. "Monetary-Policy Rules and the Great Inflation," American Economic Review, American Economic Association, vol. 92(2), pages 115-120, May.
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