Transcript Macroeconomics

Federal Reserve Policy
David Papell
University of Houston
Economic Forecast Lunch
April 23, 2008
slide 0
The Taylor Rule
The Fed raises the nominal interest rate r when
real GDP is greater than potential GDP and
when inflation is greater than the target inflation
rate.

r     Y   (   * )  R*
(16.1)
where r is the short-term nominal interest rate set by
the Fed (the federal funds rate)
slide 1
The Taylor Rule
The Taylor rule is stabilizing.

r  (1   )   Y  R*   *
(16.2)
When inflation rises above the target inflation rate,
the Fed raises the nominal interest rate by more than
inflation rises so that the real interest rate rises.
slide 2
slide 3
slide 4
The Taylor Rule in Practice
Forward-Looking TR
Euro Area MMR
U.S. FFR
Contemporaneous TR
slide 5 5
Fed Policy in Practice
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FFR was 5.25% from June 2006 to Sept 2007
Sept 18
4.75%
Oct 31
4.50%
Dec 11
4.25%
Jan 22
3.50%
Jan 30
3.00%
Mar 18
2.25%
April 29
slide 6
Fed Policy in Practice
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Is the Objective of the Fed to Eliminate
Recessions?
Should the Objective of the Fed be to Eliminate
Recessions?
How Should the Fed Respond
When Output Falls?
 When Inflation Rises?
 When Output Falls and Inflation Rises?
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slide 7
The Taylor Rule and the Dollar
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Suppose U.S. Inflation Rises Relative to Euro
Area Inflation
Purchasing Power Parity
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Dollar Depreciates Against the Euro
Taylor Rule
Markets Expect the Fed to Raise the FFR
 Dollar Appreciates
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Bad News About Inflation is Good News for
the Exchange Rate
slide 8
The Taylor Rule and the Dollar
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What Happened on April 10?
Euro Area Inflation Above Target
 ECB Kept Interest Rate at 4.00%
 Euro Hit New Record High Against the Dollar

slide 9