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A multiple threshold analysis of the Fed's balancing act during the Great Moderation

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  • Ahmad, Saad

Abstract

Empirical evidence has generally shown that the Federal Reserve follows close to a Taylor (1993) type rule in setting policy rates. This paper continues this line of inquiry by developing a broad nonlinear Taylor rule framework, in conjunction with real-time data, to examine the Fed's policy response during the Great Moderation, an era in which the U.S. economy experienced low output volatility and mild inflation. Our analysis finds that standard two-regime smooth transition models are unable to fully capture the Fed's nonlinear response. Thus we utilize the Multiple Regime Smooth Transition model (MRSTAR) to get a better understanding of the Fed's asymmetric preferences and opportunistic conduct of monetary policy. With the MRSTAR model we can use both inflation and the output gap as concurrent threshold variables in the Fed's policy response function and are able to determine that policy makers prioritize loss of output over inflationary concerns. Our flexible nonlinear framework is also able to convincingly show that the Fed departed from the Taylor rule during key periods in the Great Moderation as well as in the recent financial crisis.

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  • Ahmad, Saad, 2016. "A multiple threshold analysis of the Fed's balancing act during the Great Moderation," Economic Modelling, Elsevier, vol. 55(C), pages 343-358.
  • Handle: RePEc:eee:ecmode:v:55:y:2016:i:c:p:343-358
    DOI: 10.1016/j.econmod.2016.02.013
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