We estimate a forward-looking monetary policy reaction function for the postwar United States economy, before and after Volcker’s appointment as Fed Chairman in 1979. Our results point to substantial differences in the estimated rule across periods. In particular, interest rate policy in the Volcker-Greenspan period appears to have been much more sensitive to changes in expected in�ation than in the pre-Volcker period. We then compare some of the implications of the estimated rules for the equilibrium properties of in�ation and output, using a simple macroeconomic model, and show that the Volcker-Greenspan rule is stabilizing. I.

In this paper, we investigate the properties of alternative monetary policy rules using four structural macroeconometric models: the Fuhrer-Moore model, Taylor’s Multi-Country Model, the MSR model of Orphanides and Wieland, and the FRB staff model. All four models incorporate the assumptions of rational expectations, short-run nominal inertia, and long-run monetary neutrality, but differ in many other respects (e.g., the dynamics of prices and real expenditures). We compute the output-inflation volatility frontier of each model for alternative specifications of the interest rate rule, subject to an upper bound on nominal interest rate volatility. Our analysis provides strong support for rules in which the first-difference of the federal funds rate responds to the current output gap and the deviation of the one-year average inflation rate from a specified target. In all four models, first-difference rules perform much better than rules of the type proposed by Taylor (1993) and Henderson and McKibbin (1993),

Recent imperfect capital market theories predict the presence of asymmetries in the variation of small and large firms' risk over the economic cycle. Small firms with little collateral should be more strongly affected by tighter credit market conditions in a recession state than large, better collateralized ones. This paper adopts a flexible econometric model to analyse these implications empirically. Consistent with theory, small firms display the highest degree of asymmetry in their risk across recession and expansion states and this translates into a higher sensitivity of these firms' expected stock returns with respect to variables that measure credit market conditions. Recent imperfect capital market theories (e.g., Bernanke and Gertler (1989), Gertler and Gilchrist (1994), Kiyotaki and Moore (1997)) predict that changing credit market conditions can have very different effects on small and large firms' risk. Agency costs induced by asymmetry in the information held by firms and their creditors make...

The tendency for changes in the federal funds rate to be implemented gradually has been considered evidence of an interest-rate smoothing objective for the Federal Reserve. This paper investigates whether gradual movements in the federal funds rate can be explained by the dynamic structure of the economy and the uncertainty that the Fed faces regarding this structure, without recourse to including an ad-hoc interest rate smoothing argument in the objective function of the Fed. The analysis calculates the optimal funds rate policy given the structural form of the economy estimated in a VAR. In the absence of parameter uncertainty, the calculated policy responds more aggressively to changes in the economy than the observed policy, resulting in a substantially higher volatility of the funds rate than observed. Parameter uncertainty, however, limits the willingness of the Fed to deviate from the policy rule that has been previously implemented. Because the Fed has historically smoothed interest rates, the calculated policy under parameter uncertainty can account for a considerable portion of the gradualism observed in funds rate movements.

∗ Preliminary draft. Prepared for the November 2002 Carnegie-Rochsester conference. [Thanks.] The opinions expressed are those of the author and do not necessarily reflect views of the Board of Governors of the Federal Reserve System. 1

The monetary and payment system consequences of the September 11, 2001, terrorist attacks are reviewed and compared to selected U.S. banking crises. Interbank payment disruptions appear to be the central feature of all the crises reviewed. For some the initial trigger is a credit shock, while for others the initial shock is technological and operational, as in September 11, but for both types the payments system effects are similar. For various reasons, interbank payment disruptions appear likely to recur. Federal Reserve credit extension following September 11 succeeded in massively increasing the supply of banks ’ balances to satisfy the disruption-induced increase in demand and thereby ameliorate the effects of the shock. Relatively benign banking conditions helped make Fed credit policy manageable. An interbank payment disruption that coincided with less favorable banking conditions could be more difficult to manage, given current daylight credit policies. Keywords: central bank, Federal Reserve, monetary policy, discount window, payment system, September 11, banking crises, daylight credit.

the past several years, Taylor rules have attracted increased attention of analysts, policymakers, and the financial press. Taylor rules recommend a setting for the level of the federal funds rate based on the state of the economy. For instance, they may recommend raising the federal funds rate when inflation is above target or lowering the federal funds rate when a recession appears to be more of a threat. Taylor rules have become more appealing recently with the apparent breakdown in the relationship between money growth and inflation (Blinder). But, while Taylor rules have attracted considerable interest, the usefulness of rule recommendations to policymakers has not

This paper argues that interest-rate smoothing may be optimal when the effect of monetary policy is uncertain. A model is presented in which the Federal Reserve rationally learns about the policy multiplier by observing the reaction of the economy to recent choices of the interest rate. As a result of this learning process, the Fed faces greater uncertainty about the impact of its policy as it moves the interest rate away from its previous level. The optimal policy response to macroeconomic developments therefore involves gradual adjustment of the interest rate over a period of time during which the Fed is learning about the effect of its policy, consistent with the smoothness of interest rate movements found in estimated policy rules. The model also suggests that periods of active interest rate movements, by allowing the Fed to learn more effectively, may be followed by a more aggressive policy rule.

Monetary policy can be implemented effectively without reserve requirements as long as cost incentives ensure a predictable demand for settlement balances. A central bank can then achieve the level of short-term interest rates that it desires, using market-oriented instruments only. In Canada, the framework provided by rules on interbank payments settlement and by the costs of deficits and surpluses on settlement accounts provides a strong incentive for the banks and other clearing institutions to target zero balances. Reforms of this framework, to follow the introduction of the Large-Value Transfer System, will ensure its continued effectiveness and make it more transparent. An appendix outlines the process by which reserve requirements were phased out in Canada. Résumé La politique monétaire peut être mise en oeuvre avec efficacité dans un système libre de réserves obligatoires à la condition que des incitations financières rendent prévisible la demande d'encaisses de règlement. Si ...

: Financial market observers have noted that during periods of high market volatility, correlations between asset prices can differ substantially from those seen in quieter markets. For example, correlations among yield spreads were substantially higher during the fall of 1998 than in earlier or later periods. Such differences in correlations have been attributed either to structural breaks in the underlying distribution of returns or to "contagion" across markets that occurs only during periods of market turbulence. However, we argue that the differences may reflect nothing more than time-varying sampling volatility. As noted by Boyer, Gibson, and Loretan (1999), increases in the volatility of returns are generally accompanied by an increase in sampling correlations even when the true correlations are constant. We show that this result is not just of theoretical interest: When we consider quarterly measures of volatility and correlation for three pairs of asset returns, we find that t...