Introduction
The contemporary economic system is based (largely) on neo-classical concepts and principles (about economics), which discourage the use of the fiscal instrument. When we meticulously study prevailing economic model, in the United States, we learn that it also emphasizes or relies on monetary policy and instruments to realize various socioeconomic objectives. It uses Fiscal instrument only when it is necessary (during recessions and depressions); mostly it allows the Federal Reserve to devise monetary policies to 1) keep inflation at a desirable level / rate, 2) increase investment in economy and 3) to keep the exchange rate stable (a rate that ensures that products and services in the US are competitive).
Evidence suggests that as the size of the economy is growing, it is becoming quite difficult for countries to regulate the economy. The prime reason is that there are several factors, exogenous and endogenous, that affect the modern economy. Also, most of the world economies, including United States’ economy, have globalized, which suggests that political-economic changes in certain part of the world affect all economies. Furthermore, financial markets and the banking sector have grown so large that fluctuations related to them yield economic changes of massive size (Mishkin, 2007). However, these economic changes, which occur in a particular part of the world, affect some countries more than the other countries. Also, evidence also suggests that when drastic changes occur in large economies, they tend to produce larger ripple effects in comparison to smaller economies, which is quite natural and logical. Example, of the Subprime Mortgage Crisis, endorses this argument (Bordo, 2008).
For these reasons mentioned above, we understand why governments around the world are more sensitive, regarding the economy, than before, which has in return increased the size of governments. (Note: however, the governments of developed countries (such as the United States) prefer to manage economic affairs through Central Banks’ (a semi-autonomous economic/financial institution)).
In the United States, the Federal Reserve is that semi-autonomous financial/economic institution that regulates the money supply and adjusts interest rates periodically. The objective of regulating the money supply and adjusting interest rate is to 1) meets economic objectives that are embedded with political and social objectives and 2) avoid or address economic upheavals. However, we learn that the Federal Reserve has failed numerous times to 1) avoid economic crisis and 2) effectively address it. There are several reasons for that; however, one of the reasons pertains to adjustment of interest rates in short-run. The other reason could be a faulty method or system to devise monetary policy or responses.
In this academic exercise, 1) We will study monetary policy of the United States, 2) Scrutinize Statistics to understand the flaws in the policy and 3) use Taylor’s Rule to find appropriate fund rate during a particular quarter.
Monetary Policy
Before we discuss Monetary Policy (of the Federal Reserve), the mechanism of its devising and its effectiveness, it is essential to understand Monetary Policy (in general), its instruments, and its objectives. Without understanding it appropriately, it would be hard to comprehend mechanisms related to devising of monetary policy and its effectiveness.
Monetary policy is understood as a process that is itself an instrument, designed to control the cost of short-term borrowing. The objective of controlling costs, which pertains to short-term borrowing, is to regulate inflation and influence investment through interest rates. Primarily, it is Central Bank, which devices and implements monetary policy. However, at the economy has become a serious concern for governments (and thus an election campaign agenda); therefore, incumbent governments actively work with central banks (considered a semi-autonomous financial/economic institution) to achieve various kinds of socioeconomic and socio-political objectives.
In any economy, the prime concerns are economic growth and high employment level. These objectives are achieved through various means (fiscal and monetary); however, governments let central banks devise policies, both short and long run, to meet the said objectives. For instance, to intensify economic activity (increase in investment, prices, and consumption) in an economy, a government can employ an expansionary monetary policy; whereas to curb inflation and reduce the pace of growth (so that the economic /financial institutions can mature along with economic growth) governments employ a contractionary monetary policy. (Note: Contractionary Monetary Policy is also employed to influence the exchange rate, as the interest rate has a direct correlation with exchange rate).
Expansionary Monetary Policy
Expansionary policy is understood as an instrument to stimulate the economy. It is implemented by increasing the money supply in an economy. Often, central banks use open market operations to increase the supply of money in the economy. During the process of open market operations, a central bank buys treasury notes from its member banks (private banks). This process is also called printing of money, which increases the supply of money in the economy. As private banks have more money to lend, this pushes interest rates downwards (downward pressure of expansion of the supply of money on interest rates).
It is a known fact that interest rates have a negative relation to investment which implies that whenever interest rate increases, the size of investment decreases in an economy. Similarly, whenever interest rates decrease, the size of investment increases in an economy. This policy or strategy does not work in extreme or abnormal economic conditions. For instance, during the recession or depression, liquidity-trap may not allow low-interest rates to stimulate investment.
Contractionary Monetary Policy
The Contractionary Monetary Policy, on the other hand, targets inflation, which are both political and economic issues. Inflation is indirectly related to purchasing power, which means that when prices of products and services increase, the ability to buy reduces. However, it is a good incentive for producers to invest in the economy.
Governments/economies aim stable and healthy economic growth. Different studies suggest that when inflation is between 3-4%, the economy grows at a satisfactory pace. Therefore, both contractionary and monetary policy aims to keep inflation at a certain point, where it facilitates economic growth and maintains the unemployment rate at a natural level. Therefore, expansionary and monetary policies have similar objectives; however, these policies are used in different circumstances. (Note: in contractionary monetary policy too, central bank is involved in open market operations to reduce contract supply of money in an economy; the buying of bonds and securities).
Reliance on Monetary Policy
Classical and neo-classical concepts influence contemporary economic systems strongly, and in neo-classical economics, the Central Bank and its instruments are used to achieve various kinds of economic objectives. For instance, when the American economy was hit by the major economic crisis in the year 2007-8, the Federal Reserve / government emphasized on the Federal Reserve for deliverance. The Federal Reserve increased the money supply and reduced interest rates to provide quick relief and to mitigate the strength of economic crisis.
However, Keynesian economists are of the view that it is quite difficult to address an economic crisis (depression/regression) without the use of the fiscal instrument.
We learn from the systematic scrutiny of evidence that most central banks can project an economic crisis. However, since the 1960s, it is becoming increasingly difficult for central banks to predict, evade and effectively address an economic crisis. It is also quite true for Federal Reserve, which has failed to predict, evade and effectively address an economic crisis in the last four decades.
As per evidence, around twelve (12) recessions have occurred since World War II. Recessions are a mild form of Depressions, which are prolonged periods of low economic activity. It suggests that Federal Reserve repeatedly failed to project an economic crisis. Also, it also failed to address the issue effectively, as, on average, the period of these recessions was around eight months, which is almost three (3) quarters. It is an ample time to diagnose the problem and recommend/implement the remedy in accordance with the problem.
Issues related to Monetary Policy
It is quite evident that monetary policy is not as effective, in projecting, evading and addressing an economic crisis, as it is believed. The reason for this is that central banks, around the world, are not evolving at the required pace. It means that since World War II, central banks have developed instruments to proactively address economic upheavals, such as Dot-Com Bubble and Subprime Mortgage Crisis. However, the effectiveness of these instruments and prowess of Central Banks are being questioned (Brunnermeier, 2009).
Economists acknowledge, since the great depression, that perceptions, at the macro level, strongly affects the economy. The pessimism, which prevails during a certain period in an economy, adversely affects investment, which then reduces general employment level in an economy. Therefore, a central bank/Federal Reserve (of the US) must have the instruments to estimate pessimism and to address an economic crisis, which usually follows after that.
In addition to the lack of capacity to project and evade economic crisis, Federal Reserve’s monetary policy/response is slow and ineffective. The issue, about effective monetary policy, relates to the mechanisms of devising a policy. It is apparent that economic policy must change, as per requirement, almost every quarter. However, such short period seems unrealistic to several economists, as institutions such as Federal Reserve takes considerable time to devise and implement monetary policy through various financial institutions (including private banks). Another issue is related to the devising of policy.
There are two methods to devise monetary policy, regarding Federal Funds rate; Discretionary and Systematic (policy Rule) (includes mathematical/algebraic formula). Economists are divided on the effectiveness of these two methods. For instance, some economists argue that discretionary policy is not very different policy rules and therefore human wisdom should be credited more. However, the other school of thought, which opposes the discretionary policy and consider it shortsightedness (as it only focuses on short-term), argues that a policy rule is more systematic and it produces answers, which are more applicable (Taylor, 1993).
Economic/financial institutions around the world as a sort of a policy rule to address issues that pertain to stable inflation and output. In fact, a consensus is developing among various financial/economic institutions (central banks) regarding a policy rule, which facilitates in developing a robust and an effective monetary policy to address various economic issues identified by the government.
Discretionary Policy
Discretionary policy can be understood as a policy, which is not governed by any rule or formula. Central Bank implements monetary policy, about the economy, by only studying prevailing economic conditions. In such formulation of policy, there are no parameters or criteria set. Also, such policies are usually inconsistent and lack coherence (with former policies). The randomness of these policies also reduces the effectiveness of monetary instruments. However, the real issues associated with this policy are that 1) it is for short-run, 2) it lacks history, 3) it has no method to it, and 4) it lacks parameters and criteria.
Policy Rule
Policy Rule is not a more methodical policy than discretionary policy, but rather it is an effective policy with several other advantages. For instance, it has parameters and criteria associated with it, which implies that when an economy misses set targets, an efficient response develops almost automatically. Also, Policy Rule has a history and consistency. The history, which policy rule generates, allows us to understand why the certain monetary policy was devised and why it was implemented in a particular manner. Furthermore, policy rule is more consistent than discretionary policy, which gives a method to it (Taylor, The financial crisis and the policy responses: An empirical analysis of what went wrong, 2009).
Federal Reserve’s Policy
To understand the Federal Reserve’s policy, during normal and extraordinary periods, we need to study its interest rate policy. It is because the interest rate varies in accordance with the economic conditions; during recession, interest rates are low, whereas during the periods of boom, interest rates high. Therefore, a careful study of interest rates reveals 1) what are the prevailing economic conditions (as per Federal Reserve) and 2) what the Federal Reserve intends to achieve.
Through a valid and tested policy rule (mathematical and an algebraic formula), we can also learn how effective a devised monetary policy is. It would require valid data, retrieved from a valid source. Nature and other criteria, which are related to data, are determined by a policy rule itself. For this academic exercise, Taylor Rule will be used to understand how effective Federal Reserve’s policy was during different periods. We must acknowledge that Taylor Rule is not an ultimate mathematical formula to test monetary policy of a central bank; however, it is considered an effective tool to both devise and test monetary policy.
We have gathered statistical data from the Federal Reserve Bank of St. Louis. We have collected data about the categories 1) Personal Consumption Expenditure Price Index (PCECTPI), 2) Real GDP (GDPC1), 3) ESTIMATE OF POTENTIAL GDP (GDPPOT), 4) and Federal Funds Rate (DFF).
Statistics
In this section, of this academic exercise, we will present data about selected categories. Statistics will be provided in the form of tables and graphs in this section.
Data about Personal Consumption Expenditure Price Index (Quarterly), adjusted to Percentage Change From Year Ago. It converts data to the inflation data.
| Observation Date | PCECTPI_PC1 |
| 2000-01-01 | 2.5 |
| 2000-04-01 | 2.4 |
| 2000-07-01 | 2.5 |
| 2000-10-01 | 2.5 |
| 2001-01-01 | 2.3 |
| 2001-04-01 | 2.3 |
| 2001-07-01 | 1.8 |
| 2001-10-01 | 1.3 |
| 2002-01-01 | 0.8 |
| 2002-04-01 | 1.1 |
| 2002-07-01 | 1.5 |
| 2002-10-01 | 1.9 |
| 2003-01-01 | 2.5 |
| 2003-04-01 | 1.8 |
| 2003-07-01 | 1.9 |
| 2003-10-01 | 1.8 |
| 2004-01-01 | 1.9 |
| 2004-04-01 | 2.5 |
| 2004-07-01 | 2.5 |
| 2004-10-01 | 2.9 |
| 2005-01-01 | 2.6 |
| 2005-04-01 | 2.6 |
| 2005-07-01 | 3.1 |
| 2005-10-01 | 3.1 |
| 2006-01-01 | 3.0 |
| 2006-04-01 | 3.1 |
| 2006-07-01 | 2.8 |
| 2006-10-01 | 1.8 |
| 2007-01-01 | 2.3 |
| 2007-04-01 | 2.3 |
| 2007-07-01 | 2.1 |
| 2007-10-01 | 3.3 |
| 2008-01-01 | 3.3 |
| 2008-04-01 | 3.5 |
| 2008-07-01 | 4.0 |
| 2008-10-01 | 1.5 |
| 2009-01-01 | 0.0 |
| 2009-04-01 | -0.5 |
| 2009-07-01 | -0.9 |
| 2009-10-01 | 1.2 |
| 2010-01-01 | 2.1 |
| 2010-04-01 | 1.8 |
| 2010-07-01 | 1.4 |
| 2010-10-01 | 1.3 |
| 2011-01-01 | 1.7 |
| 2011-04-01 | 2.6 |
| 2011-07-01 | 2.9 |
| 2011-10-01 | 2.7 |
| 2012-01-01 | 2.5 |
| 2012-04-01 | 1.8 |
| 2012-07-01 | 1.6 |
| 2012-10-01 | 1.8 |
| 2013-01-01 | 1.5 |
| 2013-04-01 | 1.3 |
| 2013-07-01 | 1.3 |
| 2013-10-01 | 1.2 |
| 2014-01-01 | 1.4 |
| 2014-04-01 | 1.8 |
| 2014-07-01 | 1.7 |
| 2014-10-01 | 1.2 |
| 2015-01-01 | 0.3 |
| 2015-04-01 | 0.3 |
| 2015-07-01 | 0.3 |
| 2015-10-01 | 0.4 |
| 2016-01-01 | 1.0 |
| 2016-04-01 | 1.0 |
| 2016-07-01 | 1.2 |
| 2016-10-01 | 1.6 |
| 2017-01-01 | 2.0 |
| 2017-04-01 | 1.6 |
| 2017-07-01 | 1.5 |
Graph (related to Personal Consumption Expenditure Price Index)
Percent Change from Year Ago converted the data into inflation data. The data, which we have retrieved, is quarterly and it is quite apparent that there is serious fluctuation in the inflation rate, from the year 2000 to 2017. It is evident from the graph that deflation occurred after 2008, which adversely affected economic activity.
Table of the data about Real GDP (Quarterly); seasonally adjusted
| Observation date | GDPC1_PCH |
| 2000-01-01 | 0.3 |
| 2000-04-01 | 1.9 |
| 2000-07-01 | 0.1 |
| 2000-10-01 | 0.6 |
| 2001-01-01 | -0.3 |
| 2001-04-01 | 0.5 |
| 2001-07-01 | -0.3 |
| 2001-10-01 | 0.3 |
| 2002-01-01 | 0.9 |
| 2002-04-01 | 0.6 |
| 2002-07-01 | 0.5 |
| 2002-10-01 | 0.1 |
| 2003-01-01 | 0.5 |
| 2003-04-01 | 0.9 |
| 2003-07-01 | 1.7 |
| 2003-10-01 | 1.2 |
| 2004-01-01 | 0.6 |
| 2004-04-01 | 0.7 |
| 2004-07-01 | 0.9 |
| 2004-10-01 | 0.9 |
| 2005-01-01 | 1.1 |
| 2005-04-01 | 0.5 |
| 2005-07-01 | 0.8 |
| 2005-10-01 | 0.6 |
| 2006-01-01 | 1.2 |
| 2006-04-01 | 0.3 |
| 2006-07-01 | 0.1 |
| 2006-10-01 | 0.8 |
| 2007-01-01 | 0.1 |
| 2007-04-01 | 0.8 |
| 2007-07-01 | 0.7 |
| 2007-10-01 | 0.4 |
| 2008-01-01 | -0.7 |
| 2008-04-01 | 0.5 |
| 2008-07-01 | -0.5 |
| 2008-10-01 | -2.1 |
| 2009-01-01 | -1.4 |
| 2009-04-01 | -0.1 |
| 2009-07-01 | 0.3 |
| 2009-10-01 | 1.0 |
| 2010-01-01 | 0.4 |
| 2010-04-01 | 1.0 |
| 2010-07-01 | 0.7 |
| 2010-10-01 | 0.6 |
| 2011-01-01 | -0.4 |
| 2011-04-01 | 0.7 |
| 2011-07-01 | 0.2 |
| 2011-10-01 | 1.1 |
| 2012-01-01 | 0.7 |
| 2012-04-01 | 0.5 |
| 2012-07-01 | 0.1 |
| 2012-10-01 | 0.0 |
| 2013-01-01 | 0.7 |
| 2013-04-01 | 0.2 |
| 2013-07-01 | 0.8 |
| 2013-10-01 | 1.0 |
| 2014-01-01 | -0.2 |
| 2014-04-01 | 1.1 |
| 2014-07-01 | 1.3 |
| 2014-10-01 | 0.5 |
| 2015-01-01 | 0.8 |
| 2015-04-01 | 0.7 |
| 2015-07-01 | 0.4 |
| 2015-10-01 | 0.1 |
| 2016-01-01 | 0.1 |
| 2016-04-01 | 0.6 |
| 2016-07-01 | 0.7 |
| 2016-10-01 | 0.4 |
| 2017-01-01 | 0.3 |
| 2017-04-01 | 0.8 |
| 2017-07-01 | 0.8 |
Graph about Real GDP
(Note: the gathered statistical information, about Real GDP, is quarterly)
Again, it is evident to us that in the post-recession economy, of United States, Real GDP dwindled enormously, causing massive unemployment. Government and Federal Reserve’s measures tried to revive the American economy, but the economy could not truly resuscitate.
Data about Real Potential Gross Domestic Product (frequency: Quarterly) NOT SEASONALLY ADJUSTED.
| Observation date | GDPPOT_PCH |
| 2000-01-01 | 1.0 |
| 2000-04-01 | 1.0 |
| 2000-07-01 | 1.0 |
| 2000-10-01 | 0.9 |
| 2001-01-01 | 0.9 |
| 2001-04-01 | 0.9 |
| 2001-07-01 | 0.8 |
| 2001-10-01 | 0.8 |
| 2002-01-01 | 0.7 |
| 2002-04-01 | 0.7 |
| 2002-07-01 | 0.7 |
| 2002-10-01 | 0.6 |
| 2003-01-01 | 0.6 |
| 2003-04-01 | 0.6 |
| 2003-07-01 | 0.6 |
| 2003-10-01 | 0.6 |
| 2004-01-01 | 0.6 |
| 2004-04-01 | 0.6 |
| 2004-07-01 | 0.6 |
| 2004-10-01 | 0.6 |
| 2005-01-01 | 0.6 |
| 2005-04-01 | 0.6 |
| 2005-07-01 | 0.6 |
| 2005-10-01 | 0.6 |
| 2006-01-01 | 0.5 |
| 2006-04-01 | 0.5 |
| 2006-07-01 | 0.5 |
| 2006-10-01 | 0.5 |
| 2007-01-01 | 0.4 |
| 2007-04-01 | 0.4 |
| 2007-07-01 | 0.4 |
| 2007-10-01 | 0.4 |
| 2008-01-01 | 0.4 |
| 2008-04-01 | 0.4 |
| 2008-07-01 | 0.4 |
| 2008-10-01 | 0.4 |
| 2009-01-01 | 0.4 |
| 2009-04-01 | 0.3 |
| 2009-07-01 | 0.3 |
| 2009-10-01 | 0.3 |
| 2010-01-01 | 0.2 |
| 2010-04-01 | 0.2 |
| 2010-07-01 | 0.2 |
| 2010-10-01 | 0.2 |
| 2011-01-01 | 0.3 |
| 2011-04-01 | 0.3 |
| 2011-07-01 | 0.3 |
| 2011-10-01 | 0.3 |
| 2012-01-01 | 0.3 |
| 2012-04-01 | 0.3 |
| 2012-07-01 | 0.3 |
| 2012-10-01 | 0.4 |
| 2013-01-01 | 0.4 |
| 2013-04-01 | 0.4 |
| 2013-07-01 | 0.4 |
| 2013-10-01 | 0.4 |
| 2014-01-01 | 0.4 |
| 2014-04-01 | 0.4 |
| 2014-07-01 | 0.4 |
| 2014-10-01 | 0.4 |
| 2015-01-01 | 0.4 |
| 2015-04-01 | 0.4 |
| 2015-07-01 | 0.4 |
| 2015-10-01 | 0.4 |
| 2016-01-01 | 0.4 |
| 2016-04-01 | 0.4 |
| 2016-07-01 | 0.4 |
| 2016-10-01 | 0.4 |
| 2017-01-01 | 0.4 |
| 2017-04-01 | 0.4 |
| 2017-07-01 | 0.4 |
| 2017-10-01 | 0.4 |
| 2018-01-01 | 0.4 |
| 2018-04-01 | 0.4 |
| 2018-07-01 | 0.4 |
| 2018-10-01 | 0.4 |
| 2019-01-01 | 0.4 |
| 2019-04-01 | 0.4 |
| 2019-07-01 | 0.4 |
| 2019-10-01 | 0.4 |
| 2020-01-01 | 0.4 |
| 2020-04-01 | 0.5 |
| 2020-07-01 | 0.5 |
| 2020-10-01 | 0.5 |
| 2021-01-01 | 0.5 |
| 2021-04-01 | 0.5 |
| 2021-07-01 | 0.5 |
| 2021-10-01 | 0.5 |
| 2022-01-01 | 0.5 |
| 2022-04-01 | 0.5 |
| 2022-07-01 | 0.5 |
| 2022-10-01 | 0.5 |
| 2023-01-01 | 0.5 |
| 2023-04-01 | 0.5 |
| 2023-07-01 | 0.5 |
| 2023-10-01 | 0.5 |
| 2024-01-01 | 0.5 |
| 2024-04-01 | 0.5 |
| 2024-07-01 | 0.5 |
| 2024-10-01 | 0.5 |
| 2025-01-01 | 0.5 |
| 2025-04-01 | 0.5 |
| 2025-07-01 | 0.5 |
| 2025-10-01 | 0.5 |
| 2026-01-01 | 0.5 |
| 2026-04-01 | 0.5 |
| 2026-07-01 | 0.5 |
| 2026-10-01 | 0.5 |
| 2027-01-01 | 0.5 |
| 2027-04-01 | 0.5 |
| 2027-07-01 | 0.5 |
Graph about Potential Real GDP (Quarterly)
Potential GDP is projected by keeping in consideration several factors; however, two factors are the most important of all. One of the two pertains to the potential/capacity of the economy and other is regarding prevailing/future economic conditions.
Data about Effective Federal Funds Rate, which is not seasonally adjusted (frequency of data is quarterly)
| Observation date | FED FUNDS |
| 2000-01-01 | 5.68 |
| 2000-04-01 | 6.27 |
| 2000-07-01 | 6.52 |
| 2000-10-01 | 6.47 |
| 2001-01-01 | 5.59 |
| 2001-04-01 | 4.33 |
| 2001-07-01 | 3.50 |
| 2001-10-01 | 2.13 |
| 2002-01-01 | 1.73 |
| 2002-04-01 | 1.75 |
| 2002-07-01 | 1.74 |
| 2002-10-01 | 1.44 |
| 2003-01-01 | 1.25 |
| 2003-04-01 | 1.25 |
| 2003-07-01 | 1.02 |
| 2003-10-01 | 1.00 |
| 2004-01-01 | 1.00 |
| 2004-04-01 | 1.01 |
| 2004-07-01 | 1.43 |
| 2004-10-01 | 1.95 |
| 2005-01-01 | 2.47 |
| 2005-04-01 | 2.94 |
| 2005-07-01 | 3.46 |
| 2005-10-01 | 3.98 |
| 2006-01-01 | 4.46 |
| 2006-04-01 | 4.91 |
| 2006-07-01 | 5.25 |
| 2006-10-01 | 5.25 |
| 2007-01-01 | 5.26 |
| 2007-04-01 | 5.25 |
| 2007-07-01 | 5.07 |
| 2007-10-01 | 4.50 |
| 2008-01-01 | 3.18 |
| 2008-04-01 | 2.09 |
| 2008-07-01 | 1.94 |
| 2008-10-01 | 0.51 |
| 2009-01-01 | 0.18 |
| 2009-04-01 | 0.18 |
| 2009-07-01 | 0.16 |
| 2009-10-01 | 0.12 |
| 2010-01-01 | 0.13 |
| 2010-04-01 | 0.19 |
| 2010-07-01 | 0.19 |
| 2010-10-01 | 0.19 |
| 2011-01-01 | 0.16 |
| 2011-04-01 | 0.09 |
| 2011-07-01 | 0.08 |
| 2011-10-01 | 0.07 |
| 2012-01-01 | 0.10 |
| 2012-04-01 | 0.15 |
| 2012-07-01 | 0.14 |
| 2012-10-01 | 0.16 |
| 2013-01-01 | 0.14 |
| 2013-04-01 | 0.12 |
| 2013-07-01 | 0.08 |
| 2013-10-01 | 0.09 |
| 2014-01-01 | 0.07 |
| 2014-04-01 | 0.09 |
| 2014-07-01 | 0.09 |
| 2014-10-01 | 0.10 |
| 2015-01-01 | 0.11 |
| 2015-04-01 | 0.12 |
| 2015-07-01 | 0.14 |
| 2015-10-01 | 0.16 |
| 2016-01-01 | 0.36 |
| 2016-04-01 | 0.37 |
| 2016-07-01 | 0.40 |
| 2016-10-01 | 0.45 |
| 2017-01-01 | 0.70 |
| 2017-04-01 | 0.95 |
| 2017-07-01 | 1.15 |
Graph about Effective Federal Funds Rate
Fed Funds Rate is in fact interest rate, which affects both investment and exchange rates. After the 2007 economic crisis, the Federal Reserve lowered interest rates to stimulate the economy. However, as the consumption had reduced; therefore, the monetary policy could not produce desired results. Some economists assert that the Federal Reserve could not estimate effective interest rates.
Analysis
In this section, of this academic exercise, we will find gaps between 1) inflation and targeted inflation and 2) Real GDP and Potential GDP. We will use this information for Taylor Rule.
| Frequency: Quarterly | Frequency: Quarterly | |||||||
| Observation Date | PCECTPI_PC1 | Targeted Inflation | GAP | observation date | GDPC1_PCH | observation date | GDPPOT_PCH | Gap |
| 2000-01-01 | 2.5 | 2 | 0.5 | 2000-01-01 | 0.3 | 2000-01-01 | 1.0 | -0.7 |
| 2000-04-01 | 2.4 | 2 | 0.4 | 2000-04-01 | 1.9 | 2000-04-01 | 1.0 | 0.9 |
| 2000-07-01 | 2.5 | 2 | 0.5 | 2000-07-01 | 0.1 | 2000-07-01 | 1.0 | -0.8 |
| 2000-10-01 | 2.5 | 2 | 0.5 | 2000-10-01 | 0.6 | 2000-10-01 | 0.9 | -0.4 |
| 2001-01-01 | 2.3 | 2 | 0.3 | 2001-01-01 | -0.3 | 2001-01-01 | 0.9 | -1.2 |
| 2001-04-01 | 2.3 | 2 | 0.3 | 2001-04-01 | 0.5 | 2001-04-01 | 0.9 | -0.3 |
| 2001-07-01 | 1.8 | 2 | -0.2 | 2001-07-01 | -0.3 | 2001-07-01 | 0.8 | -1.1 |
| 2001-10-01 | 1.3 | 2 | -0.7 | 2001-10-01 | 0.3 | 2001-10-01 | 0.8 | -0.5 |
| 2002-01-01 | 0.8 | 2 | -1.2 | 2002-01-01 | 0.9 | 2002-01-01 | 0.7 | 0.2 |
| 2002-04-01 | 1.1 | 2 | -0.9 | 2002-04-01 | 0.6 | 2002-04-01 | 0.7 | -0.1 |
| 2002-07-01 | 1.5 | 2 | -0.5 | 2002-07-01 | 0.5 | 2002-07-01 | 0.7 | -0.2 |
| 2002-10-01 | 1.9 | 2 | -0.1 | 2002-10-01 | 0.1 | 2002-10-01 | 0.6 | -0.6 |
| 2003-01-01 | 2.5 | 2 | 0.5 | 2003-01-01 | 0.5 | 2003-01-01 | 0.6 | -0.1 |
| 2003-04-01 | 1.8 | 2 | -0.2 | 2003-04-01 | 0.9 | 2003-04-01 | 0.6 | 0.3 |
| 2003-07-01 | 1.9 | 2 | -0.1 | 2003-07-01 | 1.7 | 2003-07-01 | 0.6 | 1.1 |
| 2003-10-01 | 1.8 | 2 | -0.2 | 2003-10-01 | 1.2 | 2003-10-01 | 0.6 | 0.6 |
| 2004-01-01 | 1.9 | 2 | -0.1 | 2004-01-01 | 0.6 | 2004-01-01 | 0.6 | 0.0 |
| 2004-04-01 | 2.5 | 2 | 0.5 | 2004-04-01 | 0.7 | 2004-04-01 | 0.6 | 0.1 |
| 2004-07-01 | 2.5 | 2 | 0.5 | 2004-07-01 | 0.9 | 2004-07-01 | 0.6 | 0.3 |
| 2004-10-01 | 2.9 | 2 | 0.9 | 2004-10-01 | 0.9 | 2004-10-01 | 0.6 | 0.2 |
| 2005-01-01 | 2.6 | 2 | 0.6 | 2005-01-01 | 1.1 | 2005-01-01 | 0.6 | 0.4 |
| 2005-04-01 | 2.6 | 2 | 0.6 | 2005-04-01 | 0.5 | 2005-04-01 | 0.6 | -0.1 |
| 2005-07-01 | 3.1 | 2 | 1.1 | 2005-07-01 | 0.8 | 2005-07-01 | 0.6 | 0.2 |
| 2005-10-01 | 3.1 | 2 | 1.1 | 2005-10-01 | 0.6 | 2005-10-01 | 0.6 | 0.0 |
| 2006-01-01 | 3.0 | 2 | 1.0 | 2006-01-01 | 1.2 | 2006-01-01 | 0.5 | 0.7 |
| 2006-04-01 | 3.1 | 2 | 1.1 | 2006-04-01 | 0.3 | 2006-04-01 | 0.5 | -0.2 |
| 2006-07-01 | 2.8 | 2 | 0.8 | 2006-07-01 | 0.1 | 2006-07-01 | 0.5 | -0.4 |
| 2006-10-01 | 1.8 | 2 | -0.2 | 2006-10-01 | 0.8 | 2006-10-01 | 0.5 | 0.3 |
| 2007-01-01 | 2.3 | 2 | 0.3 | 2007-01-01 | 0.1 | 2007-01-01 | 0.4 | -0.4 |
| 2007-04-01 | 2.3 | 2 | 0.3 | 2007-04-01 | 0.8 | 2007-04-01 | 0.4 | 0.3 |
| 2007-07-01 | 2.1 | 2 | 0.1 | 2007-07-01 | 0.7 | 2007-07-01 | 0.4 | 0.2 |
| 2007-10-01 | 3.3 | 2 | 1.3 | 2007-10-01 | 0.4 | 2007-10-01 | 0.4 | -0.1 |
| 2008-01-01 | 3.3 | 2 | 1.3 | 2008-01-01 | -0.7 | 2008-01-01 | 0.4 | -1.1 |
| 2008-04-01 | 3.5 | 2 | 1.5 | 2008-04-01 | 0.5 | 2008-04-01 | 0.4 | 0.1 |
| 2008-07-01 | 4.0 | 2 | 2.0 | 2008-07-01 | -0.5 | 2008-07-01 | 0.4 | -0.9 |
| 2008-10-01 | 1.5 | 2 | -0.5 | 2008-10-01 | -2.1 | 2008-10-01 | 0.4 | -2.5 |
| 2009-01-01 | 0.0 | 2 | -2.0 | 2009-01-01 | -1.4 | 2009-01-01 | 0.4 | -1.7 |
| 2009-04-01 | -0.5 | 2 | -2.5 | 2009-04-01 | -0.1 | 2009-04-01 | 0.3 | -0.4 |
| 2009-07-01 | -0.9 | 2 | -2.9 | 2009-07-01 | 0.3 | 2009-07-01 | 0.3 | 0.1 |
| 2009-10-01 | 1.2 | 2 | -0.8 | 2009-10-01 | 1.0 | 2009-10-01 | 0.3 | 0.7 |
| 2010-01-01 | 2.1 | 2 | 0.1 | 2010-01-01 | 0.4 | 2010-01-01 | 0.2 | 0.2 |
| 2010-04-01 | 1.8 | 2 | -0.2 | 2010-04-01 | 1.0 | 2010-04-01 | 0.2 | 0.7 |
| 2010-07-01 | 1.4 | 2 | -0.6 | 2010-07-01 | 0.7 | 2010-07-01 | 0.2 | 0.5 |
| 2010-10-01 | 1.3 | 2 | -0.7 | 2010-10-01 | 0.6 | 2010-10-01 | 0.2 | 0.4 |
| 2011-01-01 | 1.7 | 2 | -0.3 | 2011-01-01 | -0.4 | 2011-01-01 | 0.3 | -0.6 |
| 2011-04-01 | 2.6 | 2 | 0.6 | 2011-04-01 | 0.7 | 2011-04-01 | 0.3 | 0.5 |
| 2011-07-01 | 2.9 | 2 | 0.9 | 2011-07-01 | 0.2 | 2011-07-01 | 0.3 | -0.1 |
| 2011-10-01 | 2.7 | 2 | 0.7 | 2011-10-01 | 1.1 | 2011-10-01 | 0.3 | 0.8 |
| 2012-01-01 | 2.5 | 2 | 0.5 | 2012-01-01 | 0.7 | 2012-01-01 | 0.3 | 0.3 |
| 2012-04-01 | 1.8 | 2 | -0.2 | 2012-04-01 | 0.5 | 2012-04-01 | 0.3 | 0.1 |
| 2012-07-01 | 1.6 | 2 | -0.4 | 2012-07-01 | 0.1 | 2012-07-01 | 0.3 | -0.2 |
| 2012-10-01 | 1.8 | 2 | -0.2 | 2012-10-01 | 0.0 | 2012-10-01 | 0.4 | -0.3 |
| 2013-01-01 | 1.5 | 2 | -0.5 | 2013-01-01 | 0.7 | 2013-01-01 | 0.4 | 0.3 |
| 2013-04-01 | 1.3 | 2 | -0.7 | 2013-04-01 | 0.2 | 2013-04-01 | 0.4 | -0.2 |
| 2013-07-01 | 1.3 | 2 | -0.7 | 2013-07-01 | 0.8 | 2013-07-01 | 0.4 | 0.4 |
| 2013-10-01 | 1.2 | 2 | -0.8 | 2013-10-01 | 1.0 | 2013-10-01 | 0.4 | 0.6 |
| 2014-01-01 | 1.4 | 2 | -0.6 | 2014-01-01 | -0.2 | 2014-01-01 | 0.4 | -0.6 |
| 2014-04-01 | 1.8 | 2 | -0.2 | 2014-04-01 | 1.1 | 2014-04-01 | 0.4 | 0.7 |
| 2014-07-01 | 1.7 | 2 | -0.3 | 2014-07-01 | 1.3 | 2014-07-01 | 0.4 | 0.9 |
| 2014-10-01 | 1.2 | 2 | -0.8 | 2014-10-01 | 0.5 | 2014-10-01 | 0.4 | 0.1 |
| 2015-01-01 | 0.3 | 2 | -1.7 | 2015-01-01 | 0.8 | 2015-01-01 | 0.4 | 0.4 |
| 2015-04-01 | 0.3 | 2 | -1.7 | 2015-04-01 | 0.7 | 2015-04-01 | 0.4 | 0.3 |
| 2015-07-01 | 0.3 | 2 | -1.7 | 2015-07-01 | 0.4 | 2015-07-01 | 0.4 | 0.0 |
| 2015-10-01 | 0.4 | 2 | -1.6 | 2015-10-01 | 0.1 | 2015-10-01 | 0.4 | -0.3 |
| 2016-01-01 | 1.0 | 2 | -1.0 | 2016-01-01 | 0.1 | 2016-01-01 | 0.4 | -0.2 |
| 2016-04-01 | 1.0 | 2 | -1.0 | 2016-04-01 | 0.6 | 2016-04-01 | 0.4 | 0.2 |
| 2016-07-01 | 1.2 | 2 | -0.8 | 2016-07-01 | 0.7 | 2016-07-01 | 0.4 | 0.3 |
| 2016-10-01 | 1.6 | 2 | -0.4 | 2016-10-01 | 0.4 | 2016-10-01 | 0.4 | 0.1 |
| 2017-01-01 | 2.0 | 2 | 0.0 | 2017-01-01 | 0.3 | 2017-01-01 | 0.4 | -0.1 |
| 2017-04-01 | 1.6 | 2 | -0.4 | 2017-04-01 | 0.8 | 2017-04-01 | 0.4 | 0.4 |
| 2017-07-01 | 1.5 | 2 | -0.5 | 2017-07-01 | 0.8 | 2017-07-01 | 0.4 | 0.4 |
Graphs related to gaps (Inflationary and GDP)
From the study of the gaps, we learn that the inflationary gap has occurred around 10 times, whereas the deflationary gap has occurred around 12 times. (Note: when the gap has increased from 0.5/-0.5, I have identified as an inflationary/deflationary gap)
Taylor Rule’ Application
| R=Federal Fund Rate (Taylor Rule) | The gap between actual fund rate and calculated (Taylor) |
| 4.420571654 | -1.9 |
| 5.115704607 | -2.7 |
| 4.359204524 | -1.8 |
| 4.539361411 | -2.0 |
| 3.818860196 | -1.5 |
| 4.314508736 | -2.0 |
| 2.983670793 | -1.2 |
| 2.612652759 | -1.3 |
| 2.33954863 | -1.5 |
| 2.54934984 | -1.5 |
| 3.166158422 | -1.6 |
| 3.445096415 | -1.5 |
| 4.599918869 | -2.1 |
| 3.89449626 | -2.1 |
| 4.674793669 | -2.8 |
| 4.184215841 | -2.4 |
| 3.780345801 | -1.9 |
| 4.835949747 | -2.3 |
| 4.931476648 | -2.5 |
| 5.489896302 | -2.6 |
| 5.281834986 | -2.7 |
| 4.798297639 | -2.2 |
| 5.866288759 | -2.8 |
| 5.644983546 | -2.5 |
| 6.190007338 | -3.2 |
| 5.519361847 | -2.4 |
| 4.727044876 | -2.0 |
| 4.030462147 | -2.2 |
| 3.957889049 | -1.7 |
| 4.791099694 | -2.5 |
| 4.474941925 | -2.3 |
| 5.921479471 | -2.6 |
| 4.591796062 | -1.3 |
| 6.351083727 | -2.8 |
| 5.894089871 | -1.9 |
| 0.021445969 | 1.5 |
| -1.370895385 | 1.4 |
| -0.546405624 | 0.0 |
| -0.302741147 | -0.6 |
| 4.205359035 | -3.0 |
| 4.643112898 | -2.5 |
| 5.384824408 | -3.6 |
| 4.212878275 | -2.8 |
| 3.832762052 | -2.5 |
| 2.313299616 | -0.6 |
| 5.734161856 | -3.1 |
| 5.13869614 | -2.3 |
| 6.334580368 | -3.7 |
| 5.278539146 | -2.8 |
| 3.855159461 | -2.1 |
| 3.020024356 | -1.5 |
| 3.172402707 | -1.4 |
| 3.749143848 | -2.2 |
| 2.657034463 | -1.4 |
| 3.465341529 | -2.2 |
| 3.547727685 | -2.3 |
| 2.265517215 | -0.9 |
| 4.564999295 | -2.8 |
| 4.615749006 | -2.9 |
| 2.905966694 | -1.7 |
| 1.878031367 | -1.6 |
| 1.709330039 | -1.5 |
| 1.41962161 | -1.1 |
| 1.2318572 | -0.8 |
| 2.115662355 | -1.2 |
| 2.803319584 | -1.8 |
| 3.156985051 | -2.0 |
| 3.506894068 | -1.9 |
| 3.921659657 | -1.9 |
| 3.804593233 | -2.3 |
| 3.737574517 | -2.2 |
Pro-cyclical nature of Money Supply
Economists assert that Federal Reserve’s money supply policy was pro-cyclical and it did not have a true method or logic to it. When inflation increased, the Federal Reserve increased interest rates, and when economic activity slowed, it employed expansionary monetary policy.
| FED FUNDS | GDPC1_PCH |
| 5.68 | 0.3 |
| 6.27 | 1.9 |
| 6.52 | 0.1 |
| 6.47 | 0.6 |
| 5.59 | -0.3 |
| 4.33 | 0.5 |
| 3.50 | -0.3 |
| 2.13 | 0.3 |
| 1.73 | 0.9 |
| 1.75 | 0.6 |
| 1.74 | 0.5 |
| 1.44 | 0.1 |
| 1.25 | 0.5 |
| 1.25 | 0.9 |
| 1.02 | 1.7 |
| 1.00 | 1.2 |
| 1.00 | 0.6 |
| 1.01 | 0.7 |
| 1.43 | 0.9 |
| 1.95 | 0.9 |
| 2.47 | 1.1 |
| 2.94 | 0.5 |
| 3.46 | 0.8 |
| 3.98 | 0.6 |
| 4.46 | 1.2 |
| 4.91 | 0.3 |
| 5.25 | 0.1 |
| 5.25 | 0.8 |
| 5.26 | 0.1 |
| 5.25 | 0.8 |
| 5.07 | 0.7 |
| 4.50 | 0.4 |
| 3.18 | -0.7 |
| 2.09 | 0.5 |
| 1.94 | -0.5 |
| 0.51 | -2.1 |
| 0.18 | -1.4 |
| 0.18 | -0.1 |
| 0.16 | 0.3 |
| 0.12 | 1.0 |
| 0.13 | 0.4 |
| 0.19 | 1.0 |
| 0.19 | 0.7 |
| 0.19 | 0.6 |
| 0.16 | -0.4 |
| 0.09 | 0.7 |
| 0.08 | 0.2 |
| 0.07 | 1.1 |
| 0.10 | 0.7 |
| 0.15 | 0.5 |
| 0.14 | 0.1 |
| 0.16 | 0.0 |
| 0.14 | 0.7 |
| 0.12 | 0.2 |
| 0.08 | 0.8 |
| 0.09 | 1.0 |
| 0.07 | -0.2 |
| 0.09 | 1.1 |
| 0.09 | 1.3 |
| 0.10 | 0.5 |
| 0.11 | 0.8 |
| 0.12 | 0.7 |
| 0.14 | 0.4 |
| 0.16 | 0.1 |
| 0.36 | 0.1 |
| 0.37 | 0.6 |
| 0.40 | 0.7 |
| 0.45 | 0.4 |
| 0.70 | 0.3 |
| 0.95 | 0.8 |
| 1.15 | 0.8 |
Graph
It is very apparent from the table and graphs that the money supply had become very pro-cyclical; however, after the start of the recession, the pro-cyclical nature of money supply started to disappear. Though in last two years money supply has again become pro-cyclical, this is evident from the graph.
Conclusion
From a study of monetary policy, of the Federal Reserve, we found that interest rates are altered, and inflation is targeted to achieve identified economic objectives. The prime objectives seem to be stable economic growth and healthy inflation rate. From the analysis of data, we learn that deflationary gap, about GDP, occurred around 20 times, whereas inflationary gap occurred around 10 times. From the estimation Taylor Rule, we learned that most of the times, interest rates were set lower than what they should be. From the beginning of subprime mortgage crisis in the year 2009, the gap between the estimated Fed Funds Rate and Actual Feds Fund Rate decreased evidently. However, the gap began to grow, evidently, after the year 2009.
References
Bordo, M. D. (2008). An historical perspective on the crisis of 2007-2008. National Bureau of Economic Research.
Brunnermeier, M. K. (2009). Deciphering the liquidity and credit crunch 2007-2008. Journal of Economic perspectives, 21(1), 77-100.
Mishkin, F. S. (2007). The economics of money, banking, and financial markets (11 ed.). Pearson education.
Taylor, J. B. (1993). Discretion versus policy rules in practice. Carnegie-Rochester conference series on public policy, 39, pp. 195-214. North-Holland.
Taylor, J. B. (2009). The financial crisis and the policy responses: An empirical analysis of what went wrong. Working Paper No.14631. National Bureau of Economic Research.
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