slide 0 Federal Reserve Policy David Papell University of Houston Economic Forecast Lunch April 23, 2008

slide 1 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. 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) where r is the short-term nominal interest rate set by the Fed (the federal funds rate)

slide 2 The Taylor Rule The Taylor rule is stabilizing. 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. 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.

slide 3 The Taylor Rule in Practice

slide 4 The Taylor Rule in Practice

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

slide 6 Fed Policy in Practice FFR was 5.25% from June 2006 to Sept 2007 FFR was 5.25% from June 2006 to Sept 2007 Sept % Sept % Oct % Oct % Dec % Dec % Jan % Jan % Jan % Jan % Mar % Mar % April 29 April 29

slide 7 Fed Policy in Practice Is the Objective of the Fed to Eliminate Recessions? Is the Objective of the Fed to Eliminate Recessions? Should the Objective of the Fed be to Eliminate Recessions? Should the Objective of the Fed be to Eliminate Recessions? How Should the Fed Respond How Should the Fed Respond When Output Falls? When Output Falls? When Inflation Rises? When Inflation Rises? When Output Falls and Inflation Rises? When Output Falls and Inflation Rises?

slide 8 The Taylor Rule and the Dollar Suppose U.S. Inflation Rises Relative to Euro Area Inflation Suppose U.S. Inflation Rises Relative to Euro Area Inflation Purchasing Power Parity Purchasing Power Parity Dollar Depreciates Against the Euro Dollar Depreciates Against the Euro Taylor Rule Taylor Rule Markets Expect the Fed to Raise the FFR Markets Expect the Fed to Raise the FFR Dollar Appreciates Dollar Appreciates Bad News About Inflation is Good News for the Exchange Rate Bad News About Inflation is Good News for the Exchange Rate

slide 9 The Taylor Rule and the Dollar What Happened on April 10? What Happened on April 10? Euro Area Inflation Above Target Euro Area Inflation Above Target ECB Kept Interest Rate at 4.00% ECB Kept Interest Rate at 4.00% Euro Hit New Record High Against the Dollar Euro Hit New Record High Against the Dollar