Taylors Rule on US Economic Bubbles
There have been various Economic bubbles throughout U.S history, which have led to global recessions that have affected millions of people worldwide. One of the primary reasons for these bubbles is the Federal Reserves influence on the Federal Funds Rate; an interest rate at which a depository institution lends funds, which is determined mainly by the Federal Open Market Committee. If a Federal organization has such power in their hands, then why are they failing to control it? John Taylor designed his rule in order to forecast the federal funds rate, which he believes gives a more precise estimation on what the Federal Funds Rate, should be, by suggesting how the central bank should adjust interest rates …show more content…
Before the recession we were in a period of sustainable economic activity, however the loosening of monetary policy during this time period allowed for careless gaps in the Fed Funds Rate, gaps that economist John Taylor was able to uncover. Figure 1: Federal funds rate, actual and counterfactual %
If Taylor’s rule, which accounts for GDP and actual inflation, had been applied during this period, the Federal Funds Rate would have followed Taylors rule as depicted above. In fear of the deflation felt in Japan a decade earlier the Fed intervened and drifted from normal policy decisions. Drifting from the policies that had worked so well in the previous 20 years the Fed expedited the housing boom that culminated in a housing bust. In figure two John Taylor provides an empirical link between housing starts and interest rate using regression methods.
Figure 2: The Boom-Bust housing starts compared with …show more content…
Taylor’s rule has its inconsistencies and is not prefect, however will it be able to help the Fed defend against the next bubble. Today, the interest rate is gradually raising due to our slow, but so far successfully recovery of the housing bubble. Will this gradual increase possibly led to the burst of another bubble? There are many speculations into the next bubble forming, whether it is the United States stock market, Junk Bonds, or Student Financial debt. The problem that lies within the Taylor’s Rule is the framework, as there are no concrete numbers for the variables and coefficients that are required in order to complete the rule. As Hummel, an economist, stated “ But the deeper, more critical flaw in Taylor Rules is that the long-run, equilibrium real rate of interest—or what is alternatively called the natural or neutral rate—is also unobservable. Yet these rules make the astonishing assumption that their estimates are not only correct but also relatively fixed and unchanging over extended periods”(Hummel 1). How is a rule with fixed assumptions going to provide a guide that is so complex and constantly changing? Cochrane, an economist who studied at
There have been various Economic bubbles throughout U.S history, which have led to global recessions that have affected millions of people worldwide. One of the primary reasons for these bubbles is the Federal Reserves influence on the Federal Funds Rate; an interest rate at which a depository institution lends funds, which is determined mainly by the Federal Open Market Committee. If a Federal organization has such power in their hands, then why are they failing to control it? John Taylor designed his rule in order to forecast the federal funds rate, which he believes gives a more precise estimation on what the Federal Funds Rate, should be, by suggesting how the central bank should adjust interest rates …show more content…
Before the recession we were in a period of sustainable economic activity, however the loosening of monetary policy during this time period allowed for careless gaps in the Fed Funds Rate, gaps that economist John Taylor was able to uncover. Figure 1: Federal funds rate, actual and counterfactual %
If Taylor’s rule, which accounts for GDP and actual inflation, had been applied during this period, the Federal Funds Rate would have followed Taylors rule as depicted above. In fear of the deflation felt in Japan a decade earlier the Fed intervened and drifted from normal policy decisions. Drifting from the policies that had worked so well in the previous 20 years the Fed expedited the housing boom that culminated in a housing bust. In figure two John Taylor provides an empirical link between housing starts and interest rate using regression methods.
Figure 2: The Boom-Bust housing starts compared with …show more content…
Taylor’s rule has its inconsistencies and is not prefect, however will it be able to help the Fed defend against the next bubble. Today, the interest rate is gradually raising due to our slow, but so far successfully recovery of the housing bubble. Will this gradual increase possibly led to the burst of another bubble? There are many speculations into the next bubble forming, whether it is the United States stock market, Junk Bonds, or Student Financial debt. The problem that lies within the Taylor’s Rule is the framework, as there are no concrete numbers for the variables and coefficients that are required in order to complete the rule. As Hummel, an economist, stated “ But the deeper, more critical flaw in Taylor Rules is that the long-run, equilibrium real rate of interest—or what is alternatively called the natural or neutral rate—is also unobservable. Yet these rules make the astonishing assumption that their estimates are not only correct but also relatively fixed and unchanging over extended periods”(Hummel 1). How is a rule with fixed assumptions going to provide a guide that is so complex and constantly changing? Cochrane, an economist who studied at