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Federal Reserve Policy

Federal Reserve Policy. David Papell University of Houston Economic Forecast Lunch April 23, 2008. 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.

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Federal Reserve Policy

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  1. Federal Reserve Policy David Papell University of Houston Economic Forecast Lunch April 23, 2008

  2. 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. • where r is the short-term nominal interest rate set by the Fed (the federal funds rate)

  3. The Taylor Rule • The Taylor rule is stabilizing. • 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.

  4. The Taylor Rule in Practice

  5. The Taylor Rule in Practice

  6. The Taylor Rule in Practice Contemporaneous TR Forward-Looking TR U.S. FFR Euro Area MMR 5

  7. Fed Policy in Practice • 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

  8. Fed Policy in Practice • 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?

  9. The Taylor Rule and the Dollar • Suppose U.S. Inflation Rises Relative to Euro Area Inflation • Purchasing Power Parity • Dollar Depreciates Against the Euro • Taylor Rule • Markets Expect the Fed to Raise the FFR • Dollar Appreciates • Bad News About Inflation is Good News for the Exchange Rate

  10. The Taylor Rule and the Dollar • 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

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