Monetary Policy across the Business Cycle
Presentation
Overview
Overview
Description
This study investigates whether the reaction function of the Federal Reserve differed between periods of expansion and recession across the postwar period. We augment simple interest rate rules with and without partial adjustment to allow for differing weights on both the inflation gap and output gap across the two distinct phases of the business cycle. After accounting for inertia in the federal funds rate, we find significant differences in Fed behavior across the business cycle, specifically in their response to inflation. During expansionary times, the Fed followed the Taylor principle by increasing the federal funds rate by more than one-for-one with inflation. However, during recessionary periods, the Fed cut the coefficient on the inflation gap below one, violating the Taylor principle. We estimate a standard Markov-switching model to pinpoint the distinct periods when the parameters of the Fed’s reaction function changed. Using vintage data for the time period 1965 - 2007, we find the Fed adhered to the Taylor principle during the 1980s and late 1990s and violated the Taylor principle during the 1970s, early 1990s, and early 2000s. These results imply the Fed switched to (or was already in) a “dove” policy prior each recession in our sample.
