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Does the Fed act gradually? a VAR analysis

  • Brian Sack
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    The tendency for changes in the federal funds rate to be implemented gradually has been considered evidence of an interest-rate smoothing objective for the Federal Reserve. This paper investigates whether gradual movements in the federal funds rate can be explained by the dynamic structure of the economy and the uncertainty that the Fed faces regarding this structure, without recourse to including an ad-hoc interest rate smoothing argument in the objective function of the Fed. The analysis calculates the optimal funds rate policy given the structural form of the economy estimated in a VAR. In the absence of parameter uncertainty, the calculated policy responds more aggressively to changes in the economy than the observed policy, resulting in a substantially higher volatility of the funds rate than observed. Parameter uncertainty, however, limits the willingness of the Fed to deviate from the policy rule that has been previously implemented. Because the Fed has historically smoothed interest rates, the calculated policy under parameter uncertainty can account for a considerable portion of the gradualism observed in funds rate movements.

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    File URL: http://www.federalreserve.gov/pubs/feds/1998/199817/199817abs.html
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    File URL: http://www.federalreserve.gov/pubs/feds/1998/199817/199817pap.pdf
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    Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 1998-17.

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    Date of creation: 1998
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    Handle: RePEc:fip:fedgfe:1998-17
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    1. Richard Clarida & Jordi Gali & Mark Gertler, 1998. "Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory," NBER Working Papers 6442, National Bureau of Economic Research, Inc.
    2. Lucas, Robert Jr, 1976. "Econometric policy evaluation: A critique," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 1(1), pages 19-46, January.
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    4. Marvin Goodfriend, 1987. "Interest rate smoothing and price level trend-stationarity," Working Paper 87-03, Federal Reserve Bank of Richmond.
    5. Sims, Christopher A, 1980. "Macroeconomics and Reality," Econometrica, Econometric Society, vol. 48(1), pages 1-48, January.
    6. Christopher A. Sims, 1986. "Are forecasting models usable for policy analysis?," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 2-16.
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    10. Marvin Goodfriend, 1990. "Interest rates and the conduct of monetary policy," Working Paper 90-06, Federal Reserve Bank of Richmond.
    11. Alex Cukierman, 1989. "Why does the Fed smooth interest rates?," Proceedings, Federal Reserve Bank of St. Louis, pages 111-157.
    12. Volker Wieland, 1996. "Learning by doing and the value of optimal experimentation," Finance and Economics Discussion Series 96-5, Board of Governors of the Federal Reserve System (U.S.).
    13. Glenn D. Rudebusch, 1995. "Federal Reserve interest rate targeting, rational expectations, and the term structure," Working Papers in Applied Economic Theory 95-02, Federal Reserve Bank of San Francisco.
    14. Volker Wieland, 1998. "Monetary policy and uncertainty about the natural unemployment rate," Finance and Economics Discussion Series 1998-22, Board of Governors of the Federal Reserve System (U.S.).
    15. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
    16. McCallum, Bennett T & Nelson, Edward, 1999. "An Optimizing IS-LM Specification for Monetary Policy and Business Cycle Analysis," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 31(3), pages 296-316, August.
    17. Julio Rotemberg & Michael Woodford, 1997. "An Optimization-Based Econometric Framework for the Evaluation of Monetary Policy," NBER Chapters, in: NBER Macroeconomics Annual 1997, Volume 12, pages 297-361 National Bureau of Economic Research, Inc.
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