Richard T. Froyen

Monetary Policy Reaction Functions, Consistent Expectations, and the Burns Era

THIS PAPER ESTIMATES monetary policy reaction functions for the 197W77 period using monthly data. These estimates shed light on several questions regarding monetary policy during the Burns era. During this period the Federal Reserve expressed an increased interest in the behavior of monetary aggregates that led to the articulation of specific growth targets for these aggregates. However, a number of analysts have questioned the degree to which the Federal Reserve has systematically responded to deviations from such targets and its willingness to allow the variability of interest rates required for effective control of the money stock. Critics have also charged that during the Burns era the Federal Reserve failed to take syetematic and sustained action in response to price instability, and that attempts to curb inflation consisted of short periods of monetary stringency interspersed with periods of relative ease dictated by concerns over rising unemployment. In the international sphere, the move to a floating exchange rate for the dollar (March 1973) has raised the question of whether and to what extent Federal Reserve policy has responded to changes in the strength of the dollar. More broadly, critics have charged that the Federal Reserve has not responded in a balanced systematic way to stabilization targets, that instead it has responded erratically, attempting to achieve one goal and then another, some say in part due to

An Examination of Aggregate Price Uncertainty in Four Countries and Some Implications for Real Output

This study constructs measures of aggregate price uncertainty for four industrialized countries (Canada, West Germany, Great Britain, and the United States) and attempts to assess the extent to which more rapid and more variable price changes appear to have contributed to increased aggregate price uncertainty. For this purpose we examine the relationship across countries and through time between the rate of inflation, inflation variability, and our measures of price uncertainty. In addition we use our measures of price uncertainty to examine the hypothesis, variously put forward by Marshall, Keynes, Milton Friedman, and Okun, that higher aggregate price uncertainty is likely tor esult in lower real output and higher unemployment. Our results suggest that the higher and more variable inflation of the 1970s did increase uncertainty about the aggregate price level in Canada, Great Britain and the United States, but the evidence for West Germany would not sustain such a conclusion. Finally,we did find evidence of a significant negative output effect of aggregate price uncertainty for Canada and the United Kingdom, but not for the United States or West Germany.

Monetary Policy in a Model with a Federal Funds Market: Fixed versus Flexible Deposit Rates*

This paper examines the comparative static effects of various monetary policy instruments under the assumption of a market determined interest rate on demand deposits, and, alternatively, for the case of an exogenously fixed demand deposit rate. In both cases monetary policy effects are analyzed where the monetary policy operating target is either the Federal funds rate or a reserve aggregate. The aim of the paper is to assess the differences in monetary policy effects, for each operating procedure, between the flexible and fixed deposit rate cases. We extend previous analyses of this subject by incorporating an explicit Federal funds market in our model and providing a detailed analysis of monetary policy with a Federal funds rate operating target with both a flexible and a fixed deposit rate. Additionally we consider the differences in the role of secondary monetary policy instruments, such as the discount rate and the required reserve ratio, in the different regimes. Finally, the paper considers the implications of flexibility of the deposit rate for the feasibility of the current monetary policy strategy of using a short-run operating target (either the Federal funds rate or a reserve aggregate) to attain target

The Asymmetric Effects of Political Pressures on U.S. Monetary Policy

Abstract A number of studies have estimated reaction functions focusing solely on economic state variables such as inflation and unemployment. Other reaction function studies have focused on political measures as regressors. In this study we include both sets of variables to see if political measures are significant when we control for economic state variables. Reaction functions are estimated for the 1959–91 period and for subperiods corresponding to the tenures of different Federal Reserve Board chairmen. We find significant effects for a measure of political influence on the Federal Reserve for the whole period and some subperiods.

The Changing Relationship between Aggregate Price and Output: The British Experience

Over the past two and a half decades Great Britain has exhibited the most noticeable increase in inflation variability among the ten major noncommunist industrialized countries. In addition, there has been an apparent worsening in the output-inflation tradeoff. This paper attempts to identify and empirically assess possible causes of the deterioration in the British output-inflation tradeoff in the context of a new classical-type model. Supply-side shocks can cause an increase in the inflation rate and a decrease in real output, and it is estimatedthat such shocks interacted with inflation variability to reduce real output roughly 3.3 percent between the period 1957-1968 and the period 1969-1980. Also contributing to the deterioration in the output-inflation tradeoff, it is estimated that the decline in the natural rate of real output due to inflation variability (as hypothesized by Milton Friedman) amounted to about 2.3 to 2.5 percent between these two subperiods.

The determinants of Federal Reserve policy actions: A re-examination

In an earlier article (Journal of Macroeconomics, 1997) we presented estimates of Federal Reserve reaction functions including variables representing economic and political influences. Our goal was to examine the relative importance of political versus economic influences in determining Federal Reserve actions, as well as to see which economic state variables influenced Federal Reserve actions during various time periods. This paper extends our earlier work in three ways. First, we re-estimate the monetary policy reaction functions in our earlier study in a way which obviates possible reverse causation problems and better approximates the information set that was available to the Open Market Committee at the time its decisions were made. Second, we now have five more years of data which allows us to examine the Greenspan years more fully. Third, we divide our sample period, 1965-1994, into two sub-periods, pre-1979 and post-1979, to examine the view that the Federal Reserve evidenced greater concern for inflation in the latter sub-period. The essential change from our earlier study is to use the interval between FOMC meetings as our observation rather than a calendar month. This change is shown to have significant effects on the estimated importance of political factors and economic state variables as determinants of Federal Reserve actions.

Optimal seigniorage versus interest rate smoothing

Abstract Various studies have found support for the optimal seigniorage hypothesis in postwar U.S. data. Others find support for an interest rate smoothing hypothesis. The problem is that these hypotheses can be observationally equivalent, yet both cannot be valid at the same time. This paper finds that U.S. data do not support a key implication of the optimal seigniorage hypothesis, but do support the interest rate smoothing hypothesis during certain Fed chairman regimes.

A note on reserve requirements and monetary control with a flexible deposit rate

Abstract This paper examines the relationship between reserve ratios and monetary control when deposit rates are flexible in the short run. For a total reserves operating target, it is shown that an increase in the deposit reserve ration may raise the variance of a monetary aggregate. Under an interest rate operating target, it is also shown that the deposit reserve ratio affects both the expected value and the variance of a monetary aggregate. These findings for the two alternative operating targets differ sharply from previous results which were based on the assumption of fixed deposit rates.

Alternative Monetary Policy Rules for Small Open Economies

This paper examines the relative merits of alternative monetary policy rules for a small open economy. Rules considered target: the exchange rate, price level, nominal income, or a monetary aggregate. The standard framework employed in previous comparisons of these rules fails to take account of important features of small open economies. In particular, the standard framework fails to consider the effects on aggregate supply of exchange rate adjustments resulting from adherence to policy rules. Incorporating these effects is shown to weaken the case for targeting nominal income and, more generally, to complicate the ranking of policy rules.

The variability of output-inflation tradeoffs

Abstract This paper examines the nature of the variability of the output-inflation tradeoff in the United States, Canada, and the United Kingdom. A stochastic coefficient regression specification is used to allow for the possibility that the tradeoff varies continuously over time. Where our estimates show evidence of variability in the terms of the output-inflation tradeoff we examine the extent to which such variability might be associated with period-by-period variation in the variance of inflation and aggregate demand along lines suggested by the new classical models of Robert Lucas.