The Federal Reserve System and the federal funds rate: evaluating the Fed's rate-targeting decisions through the use of Taylor-type monetary policy rules

Michelle Lynn Mireault

ISU General Staff Papers from Iowa State University, Department of Economics

Abstract: In the U.S., monetary policy decisions are handled by our central bank, the Federal Reserve System. By targeting a desired interest rate level and using three main "tools" to adjust the money supply in order to achieve this rate, the Federal Reserve guides our economy in order to maintain its long-term goals of price stability and sustainable economic growth. To help the public better understand the actions of the Federal Reserve, economist John B. Taylor devised a monetary policy rule in 1993 that is both simple and reasonably accurate. In the decade since his pivotal rule, numerous researchers have attempted to challenge, expand, or redefine this equation to make it more accurate and useful. My paper reexamines two rules, Taylor's original rule as well as another expanded rule, by using a larger set of observations. I also present and test additional models that build on these two to determine if there are other important factors the Fed takes into account when deciding on the appropriate targeted federal funds rate. In the two models that I present, it appears that when inflation is above the target level, the Fed responds to changes in inflation and GDP much more aggressively. On the other hand, when inflation is at or below the objective, the Fed follows a policy of interest rate smoothing.

Date: 2004-01-01
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