Monetary Policy and The Global Financial Crisis: Case of The United States of America

JNKPING INTERNATIONAL BUSINESS SCHOOL
JNKPING UNIVERSITY
Master Thesis
Monetary Policy and the Global Financial Crisis:
Case of the United States of America
Masters thesis within Financial Economics

Author:
Diawoye Fofana
Tutors:
Daniel Wiberg Ph.D.

Andreas Hgberg Ph.D candidate
Master Thesis in Financial Economics

Title:
Monetary Policy and the Global Financial Crisis: Case of

the United States of America
Author:
Diawoye Fofana
Tutor:
Daniel Wiberg
Ph.D.
Andreas Hgberg
Ph.D candidate
Date:
June 2010
Keywords:
Monetary Policy, Federal Fund Rate, Global Financial Crisis
Abstract
Introduction
Since its revival in the 80s, monetary policys role and importance has reached
new highs. The Federal Reserve is the guardian of the U.S. monetary policy
and has two contrasting goals: ensure price stability and full employment. The
federal Fund rate is the Federal Reserves main policy tool in attaining these
goals. The Federal Reserve adjusts federal Fund Rates in response to different
chocks to the U.S. economy.
Problem Discussion
In 2007, the most sever crisis since the great depression unraveled. What started as a subprime mortgage problem grew and spread to the whole economy.
The severity of the crisis prompted the Federal Reserve to take drastic and unorthodox actions in order to avoid total chaos. These actions are bound to have
ramifications on future policies.
Purpose
The purpose of this paper is to determine the ramifications of the global financial crisis on future U.S. monetary policies, in the short run as well as the medium run.
Method
This paper is a hybrid of theory and practice, combining a theoretical analysis
with an empirical study. The theoretical framework incorporates an analysis of
the U.S. monetary policy since the creation of the Federal Reserve and a thorough breakdown of the global financial crisis. The empirical study focuses on
the Federal fund rate from the past two decades.
Table of Content
Table of Content ............................................................................................................. 1
Figures ............................................................................................................................. 3
Tables ............................................................................................................................... 3
1
Introduction ............................................................................................................. 1
1.1 Background ...................................................................................................... 1
1.2 Existing Research ............................................................................................ 2
1.3 Problem Discussion and Research Questions .................................................. 3
1.4 Purpose ............................................................................................................ 3
1.5 Outline ............................................................................................................. 4
Monetary Policy in the U.S.: .................................................................................. 5

2.1 The Theory of Monetary Policy ...................................................................... 6
2.1.1 Policy Goals ....................................................................................... 6
2.1.2 Monetary policy under the Glorious Thirties ................................. 7
2.1.3 Monetarist Policies: ............................................................................ 7
2.2 Role of Monetary Policy ................................................................................. 8
2.3 The Federal Reserve System and Monetary policy ....................................... 10
2.3.1 Legislative guidance: ........................................................................ 12
2.3.2 Role .................................................................................................. 13
2.3.3 The Federal Open Market Committee (FOMC) ............................... 13
2.3.3.1
Open Market Operations ............................................... 15
2.3.4 The Greenspan Standards ................................................................. 16
2.3.4.1
Discretion rather than rules: ......................................... 17
2.3.4.2
Real interest rate and the federal fund rate .................. 18
2.3.4.3
Fine-tuning: ................................................................... 19
The financial Crisis ............................................................................................... 22

3.1 How the system set up the crisis .................................................................... 22
3.1.1 Macroeconomic Imbalance .............................................................. 23
3.1.1.1
The United States Current Deficit ................................ 23
3.1.1.2
Liquidity......................................................................... 23
3.1.2 Microeconomic shakiness ................................................................ 26
3.1.2.1
Quest for higher return.................................................. 26
3.1.2.2
Securitization ................................................................. 27
3.2 The meltdown ................................................................................................ 28
3.3 Policy response .............................................................................................. 32
Empirical Analysis ................................................................................................ 35
II
4.1
4.2
4.3
5
Methodology and Data .................................................................................. 35

Analysis ......................................................................................................... 37
Results: .......................................................................................................... 42
Conclusion ............................................................................................................. 46
References...................................................................................................................... 47
Appendix .......................................................................................................................... i
Appendix A ............................................................................................................... i
Appendix B ............................................................................................................ xv
III
Figures
Figure 1: The Federal Reserve System ........................................................................... 10
Figure 2: S&P/CaseShiller U.S. national home price index. ........................................ 26
Figure 3: prine rate mortgages Vs Adjustable rate mortgage delinquency rates ............ 29
Figure 4: Subprime Mortgage Crisis .............................................................................. 30
Figure 5: FF,T1&T2 plot ................................................................................................ 39
Figure 1: FF vs. F2 vs. F2 (06-04)................................................................................. xvi
Figure 2: FF vs. F2 vs. F2 (06-04)............................................................................... xviii
Figure 3: FF vs. F2 vs. F2 (06-04).................................................................................. xx
Tables
Table 1: Reserve ratios for all depository institutions .................................................... 12
Table 2: System Open Market Account Securities Holdings, March 31, 2010.............. 15
Table 3: Target federal funds rate, 2000-2004. .............................................................. 25
Table 4: Target federal funds rate cuts in response to the crisis..................................... 33
Table 5: NAIRU rates ..................................................................................................... 36
Table 6:Descriptive Statistics ......................................................................................... 37
Table 7: Paired Correlations FF&T1, FF&T2 ................................................................ 38
Table 8: Paired T-Test FF&T1, FF&T2 ......................................................................... 38
Table 9: Entrer/Remove regression Model Summary .................................................... 40
Table 10 : Coefficientsa .................................................................................................. 40
Table 11: Model Summary, recession periods ............................................................... 41
Table 12: Coefficients .................................................................................................... 41
Introduction
Introduction
This section is intended to present the background of the work at hand. The section begins with a background of the research followed by a review of the existing literature.
After familiarizing the reader with the topic, the research question is provided as well as
the purpose of our study.
1.1
Background
Thirty years ago, monetary policy was viewed as having little to do with inflation and in
no matter an instrument for demand management. Today it is mainstream knowledge
and even self-evident that monetary policys aim is price stability. In the 80s developed
countries faced double-digit inflation. High inflation led to instability and was very
costly in terms of employment and real output. Through though monetary policies, inflation was tanned to levels judged stable1 by the end of the decade. Monetary policy
not only restored price stability but also showed it had short-term effects on the real
economy. The latter is widely used by the Federal Reserve, the United States monetary
authority.
The Federal Reserve System (Fed), the U.S. central bank, has two legislative goals;
price stability and full employment. The Fed eases monetary policy in the face of a recession to jump-start the economy, and tightens monetary policy when it faces inflationary pressure. The dual mandate is in contrast with most of its peers: the Europeans
Central Bank, the Bank of England, and the Riksbank, whom are all inflation-targeting
central banks.
The Feds dual mandate has been largely exploited during the time Alan Greenspan was
chairman. Greenspan transform the U.S. monetary policy from rule guided to discretionary. This proved very useful for the institution in the future.
In 2007 erupted the most severe financial crisis since the Great Depression, and created
havoc throughout the entire financial system. The crisis took its roots from a combina1
Arbitrary depending on the monetary institution but generally in the range of 1.5%to 3%
Introduction
tion of imprudent mortgage lending, complex financial innovation and human frailty.
More illumination on the causes of the crisis will be provided further on. As the crisis,
unraveled financial stability became the Feds chief concern, thus replacing inflation
and prompting drastic interest rate cuts. A series of ten (10) rate cuts from September 17
2007 to December 16, 2008 resulted in the federal fund rate dropping form 5.25% to in
between 0-0.25%. With the Feds primary tool at virtually zero, monetary authorities
had to be very creative in combatting the crisis. Now that the worst is behind us and the
economy has stabilized, what will be the Federal Reserves next move?
1.2
Existing Research
The monthly Federal Fund rates set by the Federal Open Market Committee (FOMC)
are highly anticipated by economic agents. Unlike its counterpart the Bank of England
that explains via macro-econometric model how it calculated its main interest rate, the
U.S. Federal Reserve applies a discretionary setting policy. The Federal Fund rates have
been subject to speculations by the markets for years. The perennial question on the
mind of economists is how monetary policy should be set.
Friedman (1960) is one of the first to tackle the issue. Friedman proposes that the central bank maintain a constant growth rate of money supply, the famous K-percent rule.
In the mid 80s monetary aggregates importance in the conduct of monetary policy
diminished considerably, Federal Fund rates became the main monetary policy tool.
Taylor (1993) prescribes a simple rule for setting federal fund rates. The Taylor rule
represents a reactive response of federal fund rate to changes in inflation and macroeconomic activity. The rule is as follow
FFt = rt + t + 0.5(yt - yt*) + 0.5(t - *)
FFt Federal fund rate
rt: Real interest rate
(yt -yt*): output gap
yt: real GDP
yt*: Trend GDP,
(t -*): inflation gap
t: Average inflation
*: target inflation
This rule indicates monetary authorities will raise federal fund rate by 0.5 of the output
gap (yt -yt*) and 0.5 of the inflation gap (t -*)
Introduction
Clarida R, Gal J, Gertler M (2000)

Since Taylors publication, many academics have built models derived from Taylors
initial work. Modification in the Taylor rule includes inflation loss functions Rudebusch
and Svensson (1998), inflation-forecasting model Batini and Haldane (1998). Models
would become more and more complex as interest in monetary policy rose: KingWolman (1999), McCallum-Nelson (1998).
Taylor (1999) conduct a study to determine the most efficient and robust model. Models
studied differ greatly from one to another, from three equations to as many as 98 equations, open and closed economies. However, all the models have one thing in common
they all are a function of the output gap and the inflation gap.
The results of Taylors study2 are surprising. Simple models fared better in determining
the appropriate monetary stance central bankers should adopt then complex ones.
1.3
Problem Discussion and Research Questions
Previous studies are delimited from the 80s to pre financial crisis. The latest to date is
Mehra Y and Minton Bs (2007) applies the Taylor rule to the Greenspan era. They
concluded that the simple rule replicates Federal Fund rates well.
The crisis has tested the Feds capacity in many ways. The Fed was force to be very
bold in its response with the use of unconventional methods never before used. There is
a vivid discussion among macroeconomist on: How the crisis will affect monetary policy in the short and medium run?
This study is a combination of theoretical analysis and empirical analysis to answer the
research question previously stated.
1.4
Purpose
The purpose of this research is to determine 1) can simple rules still mimic the federal
fund rate as it did during the Greenspan era. 2) if yes, the simple rule will be used to
determine the major guidelines of future monetary policies. If not, analyses of deviation
John B. Taylor, Monetary policy rules, National bureau of economic research
Introduction
from the simple rule and combine them with theories to determine an outlook on monetary policy.
1.5
Outline
The study will be of three sections. Section 1 will start out by explaining the structure
of the U.S. Monetary system. Then will follow a brief history of the U.S. monetary policy from the late 70s until now. Emphasize shall be made on the two decade reign of
Alan Greenspan who has introduced gradualism in monetary policy and numerous other
approaches. This will constitute our theoretical background of U.S. monetary policy.
Section two, will consist of an analysis of the financial crisis. The goal here is to understand the crisis itself. What are the sources? How has it spread? Why was it so severe?
What actions have the Feds taken?
Section 3 is an empirical analysis of the federal fund rate. The goal of this part is to determine if the federal fund rate, the primary instrument of monetary policy, can be assimilated to the Taylor rule. Ex-post data is used to calculate the Federal fund rate
based on the Taylor rule. A comparison between our results and the rates established by
the FOMC will follow. Significance will be given to crisis periods to see if correlations,
if any, still hold in such times.
Section 4 will conclude with the results of our finding and determine how future monetary policies will conducted in the short and medium run.
Readers of the thesis are expected to be familiar with basic monetary theory.
Monetary Policy in the U.S.
2 Monetary Policy in the U.S.

This section is intended to provide an analysis of the U.S. monetary policy from the
early years, explain the legal framework of the U.S. Federal Reserve system and the
decision process behind policies. The analysis will start in 1914, the year the Federal
Reserve System was established.
Section 1 is structured as follow
Part 1 is a theoretical overview of monetary policy, and will comprise of two parts: (1)
the nature of monetary policy goals; (2) the role of monetary Policy;
Part 2 will discuss of the Federal Reserve System and the U.S. Monetary policy and
comprise of two parts: (1) will be to illuminate on the structure of the Federal Reserve
System. The feds approach to monetary policy and in which way monetary policy is
decided; (2) will be a recap of uncle Sams monetary policy and the nature of the monetary policy practiced by the Fed in recent years with an emphasize one the two decade
tenure of its chairmen Alan Greenspan.
2.1 The Theory of Monetary Policy

Two macroeconomic tools lie in the hand of every government: fiscal policy and
monetary policy. The latter refers to the actions undertaken by a central bank to influence the supply money and credit to help promote economic growth. Monetary policy is
generally delegated to an independent source, the Central bank. The central bank is assumed and is in all developed countries. The major concern of any macroeconomic policy resides in the extent and the nature of the governments3 intervention.
A discretionary or activist monetary policy involves frequent government intervention
in order to achieve predefined goals. An alternative is to seek to provide a stable medium term framework that removes the ability of the monetary authorities to make discretionary changes.
2.1.1 Policy Goals
What is a goal? A Goal is a substantive objective to be achieved. When a policy
goal is achieved, it will enhance the welfare of the population. Nowadays there is a consensus; the goal of any public policymakers is to achieve three things: high employment, stable prices and rapid growth
The choice of goals made by policy makers have considerably changed throughout the
decades. Variability in goals has changed when runaway inflation started plaguing the
industrial world. In the 70s and 80s, double-digit inflation in developed countries has
proven the destructive force of inflation. Primacy was given to the control of inflation.
Studies by Khan and Senhadji (2000) have found a robust and significant relationship
between inflation and growth. Inflation, persistently over 1-3 % and 7-11% respectively
in developed and developing countries, has a negative effect on growth. When inflation
lies within the threshold, they have found a positive or non-existing relation between
inflation and growth. Robert E Lucas (2000) has shown the welfare cost of high and/or
large fluctuations in inflation ranging from ineffective investment decision, to exaggerating social inequalities.
High and volatile inflation were direct consequences of previous monetary policy. Let
us reexamine the major monetary goals from the great depression to the present.
3
Refers to the Central Bank which is an independent Government entity
2.1.2 Monetary policy under the Glorious Thirties

The predominant policies during this period were Keynesians and were fullemployment driven. Policies were countercyclical, they consisted of cooling down the
economic machine when it was overheating4 and jump starting it when it stated to stagnate or enter recession. At first, the goal was to achieve economic growth and reabsorb
unemployment thus leading to a tradeoff between inflation and unemployment.
In this context, monetary policy was used as an economic stimulus but was considered
less effective than fiscal policy. Monetary policy was then reduced to accompanying
fiscal policy. Deficits were associated with an increased supply of currency by the monetary authorities.
Inflation in the late 60s and especially in the 70s will put an end to this conception of
monetary policy. In the 70s economist were stunned to notice a permanent and constant
rise in inflation and high levels of unemployment (stagflation). High inflation was only
viewed with low employment.
The paradoxical phenomenon of stagflation gave birth the monetarist conception of inflation.
2.1.3 Monetarist Policies

The first monetarist theories emerged with the publication of a series of papers from
Clark Warburton5. Clark Warburton is the first to have provided empirical evidence of
the effect of money on the real economy. Milton Friedman (1956) followed him. It was
not until the late 70s that actual monetary policies emerged with the Keynesian economics unable to explain the coexistence of inflation with unemployment.
Monetarist considered that monetary policies were more effective than fiscal policies
(M. Friedman & Anna J. Schwartz 1963). Monetarist view high and volatile inflation as
a direct consequence of an increase in money supply. In their very influential book, A
4
5
When output grew at a rate greater than its natural rate.
"The Volume of Money and the Price Level Between the World Wars", 1945, JPE
"Monetary Theory, Full Production and the Great Depression", 1945, Econometrica
"Monetary Theory, Full Production and the Great Depression", 1945, Econometrica
Monetary history of the United States 1867-1960 Milton Friedman and Anna Schwartz
argue, inflation is always and everywhere a monetary phenomenon
Friedmans recommendations for monetary policy are listed below:
-
Monetary policy should not be used for recovery purposes because the effects in
the long run are inflationist.
It is possible to reduce inflation by gradually reducing money supply.
Faced with stagflation and the impotence of Keynesian policies, governments turned to
monetarist theories. We then observed in most countries a focus on monetary policy
with the goal of price stability.
Price stability has since become the major goal of monetary policy throughout the
world. In the case of the Fed, it is associated with full employment.
2.2 Role of Monetary Policy

The role assigned to monetary policy has change throughout time. In the 1920s
monetary policy was praise for providing stability to the system throughout its finetuning. It was widely accepted that advances in monetary policy had eliminated business cycles. In the face of recession, monetary policy would take an expansionist role
and stimulate the economy back to growth. This type of policy would stimulate banks to
participate in the financing of investment and economic recovery.
These convictions were quickly dismissed in the wake of the great depression. The pendulum swung to the other extreme. Keynes and most other economists believe that the
great depression occurred despite an aggressive expansionary policy. Temin Peter
(1989) found the contrary; the quantity of money in the United States had fallen by one
third during the great depression. His analysis is as follow:
Money supply interest rate investment and consumption income
The role assigned to monetary policy throughout the following years was to keep interest rates low so government would have a ceiling on their debt service.
These convictions resulted in the 70s and 80s spike in inflation, which ultimately led
to the revival of monetary policy as cited 2.1.2.
Today there is a consensus that price stability is the main goal of monetary policy. Other roles are associated to monetary policy depending on the country.
Let us stress out the can and cant of monetary policy.
What cant monetary policy do?
From the misinterpretations of the role of monetary policy after the great depression,
two limitations of monetary policy have been exposed: 1) pegging of interest rates, (2)
Pegging of unemployment.
For the former, history has already convinced us of the failure of cheap money policies
prevailed by Keynesians and pegging of the government bonds prices was a mistake.
The second limitation goes against current thinking. Monetary growth is seen to tend to
stimulate employment and monetary contractions to contract economic activity thus
increase unemployment. Monetary authorities can only increase or decrease employment by means or inflation and deflation respectively6.
What monetary policy can do?
History, also teaches us the first and most important lesson about what monetary policy
can do. Monetary policy can prevent money from being a major source of problem. The
severity of the great depression could have been very much been reduce if monetary
authorities hadnt made the dreadful mistake of reducing money supply and failing to be
the lender of last resorts to financial institutions. The 60s would have been less bumpy
if authorities had been less erratic in changes of direction. In the early 1966, money
supply grew too rapidly, and by the end of the year, the breaks were pushed too hard.
Expansion was resumed in late 1967 at a pace that could have only led to double digit.
The second thing monetary policy can do is to provide a stable backbone to the economy. This can be achieved by providing price stability. The economic system works best
when producers and consumers, employers and employees can assess future price
movements.
The final can do of monetary policy is to offset major disturbances in the economic system. A good example would be the massive post war expansion, monetary policy could
have cool down the economic machine. If budget deficits threatened inflation fears,
6
For thorough analysis of these two limitation refer to MILTON FRIEDMAN, "The Monetary Theory
and Policy of Henry Simons," Jour. Law and Econ., Oct. 1967, 10, p 5-11
10
monetary policy could control inflation by increasing interest rates, which would in turn
reduce the growth of money supply.
Throughout the 20th century, monetary policy has been through a series of trial and errors. Relatively a new discipline that was sided through most of the postwar, monetary
policy has been revived by inflation in the second half of the century. Inflation and deflation have proven to be very costly. Monetary policy has roared back as one or not the
most important policy tool in the governments tool kit.
2.3 The Federal Reserve System and Monetary policy

Federal Reserve System, the United States central bank, is widely regarded as the most
powerful economic policy institution in the world. The current U.S. central bank, the
Federal Reserve System (the Fed), was not established until the early years of the 20th
century. The Federal Reserve System was established in 1914, after President Woodrow
Wilson signed the Federal Reserve Act on December 23, 1913. The System consists of
a seven member Board of Governors with headquarters in Washington, D.C., and
twelve Reserve Banks located in major cities throughout the United States.
Figure 1: The Federal Reserve System
11
The Federal Reserve has three tools at its disposal for the conduct of the nations monetary policy:
Open market operations: consisting of Purchase and sales of U.S. Treasury and
Federal Agency securities. These operations are the Feds principal tool for implement
monetary policy. The Federal Open Market Committee specifies open market operations. More light shall be shed on these operations in 1.3.3.
The discount rate: interest rate charged on loans by the central banker to commercial banks and other depository institutions (discount window). There exist three
discount window programs: 1) primary credit consisting of very short-term loan (usually overnight) to healthy depository institutions. 2) Secondary credit also consisting of
short-term loans but to depository institutions facing short-term liquidity needs thus not
eligible for primary credit. 3) Seasonal credit is granted to small depository institutions
facing seasonal swings in funding needs. Eligible institutions are generally located in
agricultural and tourist areas.
The rates charged are ascendant; the primary credit rate is above the FOMC's target for
the federal funds rate. The spread between these two rates may vary. Given the premium
to market rates, institutions will use the primary rate as backup rather than a source of
funding. In the financial world, the use of discount rate usually refers to the primary
rate. The secondary rate is set above the primary rate. The seasonal rate is an average of
selected market rates. The market rates used are decided by the Board of Governors of
the Federal Reserve System and reset each first business day of each two-week reserve
maintenance period.
Reserve requirement: amount of funds that a depository institutions must have
in reserve against specified deposit liabilities. Law bound reserve requirement and the
board of Governors has sole authority over changes in reserve requirements. The following table shows the reserve ratios that are prescribed for all depository institutions,
banking and U.S. branches and agencies of foreign banks for 2010.
12
Table 1: Reserve ratios for all depository institutions
Reserve ratios
Category
Effective
date
Net transaction accounts:

o%
For the amount from $0 to (and including) $10.7 million
12-31-09
3%
For the amount over $10.7 minion to ( including) $55.2 million
12-31-09
10 %
For the amount over $55.2 million
12-31-09
o%
Non personal time deposits
12-27-90
o%
Eurocurrency liabilities
12-27-90
Source: Reserve Maintenance Manual, Federal Reserve System, October 2009
2.3.1 Legislative guidance:

As an institution created by law, the Fed is always subject to the tacit concurrence of the
Congress. In other words, it is never completely independent. Congress has throughout
legislative bills directed and/or limited the activities of the Federal Reserve. A quick
recap of the legislative acts that transformed the macroeconomic mandate of the Fed
follows:
Employment Act 1946 states it is the continuing responsibility of the Federal Government to use all practicable means . . . to foster and promote free competitive enterprise
and the general welfare, conditions under which there will be afforded useful employment opportunities, including self-employment, for those able, willing, and seeking to
work, and to promote maximum employment, production, and purchasing power (15
U.S.C. 1021.)7. Even though this does not implicitly state the Fed, it makes it take into
account.
Full Employment and Balanced Growth (Humphrey-Hawkins) Act of 1978 sought to
define the Fed macroeconomic policy. This act obliges the central bank to provide a
semiannual analysis of the state of the economy, objectives and goals set out by the
FOMC.
United States Congress Joint Economic Committee (1985, p. 1).
13
On expiration of the Humphrey-Hawkins Act, the FOMC has interpreted the charge as
follow The Federal Open Market Committee seeks monetary and financial conditions
that will foster price stability and promote sustainable growth in output.8
2.3.2
Political Role
The Federal Reserve System is governed by the by the board of Governors. The president of the United States appoints the seven members of the board for a fourteen years
term. Two board members are also designated by the president to be the Chairmen and
Vice Chairmen for a four-year term. The primary role of the board is to express the nations monetary policy.
The board members constitute the majority of the twelve-member Federal Open Market
Committee (FOMC). The other five members are selected among the presidents of the
Reserve Banks. The FOMC is required by law to meet at least four times a year, but
since 1981, eight regular yearly meetings have been. The FOMC makes the decisions
regarding the cost and availability of money and credit in the economy. The Board sets
reserve requirements and shares the responsibility with the Reserve Banks for discount
rate policy. These two functions plus open market operations constitutes the monetary
policy tools of the Federal Reserve System.
In addition to monetary policy responsibilities, the Federal Reserve Board
has regulatory and supervisory responsibilities over banks, bank holding companies,
international banking facilities in the United States, and the U.S. activities of foreignowned bank
2.3.3
The Federal Open Market Committee (FOMC)
Open market operations constitute the primary tool of national monetary policy and
they are overseen by the FOMC. These operations influence Federal Reserve balances
thus overall monetary and credit conditions. Foreign exchange market operations undertaken by the Federal Reserve are also directed by the FOMC.
Policy directives resulting from the FOMC meeting of January 31, 2006.
14
The FOMC is composed of the seven members of the Board of Governors and five of
the twelve Reserve Bank presidents. The president of the Federal Reserve Bank of New
York is a permanent member; the other presidents serve one-year terms on a rotating
basis9. The FOMC under law determines its own internal organization. Tradition has the
chairman of the Board of Governors is elected as its chairman and the president of the
Federal Reserve Bank of New York as its vice chairman. Formal meetings are held
eight times a year in Washington, D.C.
The Federal Reserve System uses advisory committees in carrying out its responsibilities. Three committees advise the Board of Governors directly:
1. Federal Advisory Council: This council, which is composed of twelve
representatives of the banking industry, consults with and advises the Board on
all matters within the Boards jurisdiction. It meets four times a year. Meetings
are held in Washington, D.C. on the first Friday of February, May, September,
and December. Annually, each Reserve Bank chooses one person to represent its
District on the Federal Advisory Committee.
2. Consumer Advisory Council: This council, established in 1976, advises the
Board on issues under the Consumer Credit Protection Act and on other matters
in the area of consumer financial services. The council represents the interests of
consumers and the financial services industry. The council meets three times a
year in Washington, D.C.
3. Thrift Institutions Advisory Council: After the passage of the Depository
Institutions
Unlike the Federal Advisory Council and the Consumer Advisory Council, the Thrift
Institutions Advisory Council is not a statutorily mandated body. It provides firsthand
advice from representatives of institutions that have an important relationship with the
Federal Reserve. The council meets with the Board in Washington, D.C. The members
are representatives from savings and loan institutions, and credit unions.
The rotating seats are filled with, one Bank president from each group: Boston, Philadelphia, and Richmond; Cleveland and Chicago; Atlanta, St. Louis, and Dallas; and Minneapolis, Kansas City, and San
Francisco.
2.3.3.1
15
Open Market Operations
Open market operations (OMOs), the purchase and sale of securities in the open market
by the Fed are a key tools used by the Federal Reserve in the implementation of monetary policy. In theory, the Federal Reserve could conduct open market operations by
purchasing or selling any type of asset. In practice, it needs to be able to buy or sell very
large volume of securities that are liquid and have a sizeable market. The U.S. Treasury
securities satisfy these conditions. The U.S. Treasury securities market is the broadest
and liquid market in the world. Transactions are over the counter and most of the trading occurs in New York City.
The Federal Reserve has guidelines that limit its holdings of individual Treasury securities to a percentage of the total amount outstanding. These guidelines are designed to
help the Federal Reserve manage the liquidity and the maturity of the System portfolio.
As of March 31, 2010 the Feds portfolio of securities also called the System open Market Account (SOMA) are illustrated in table 2.
Table 2: System Open Market Account Securities Holdings, March 31, 2010
Security type
Total par value
U.S. Treasury bills
18
U.S. Treasury notes and bonds, nominal
709
U.S. Treasury notes and bonds, inflation-indexed10
49
Federal agency debt securities11
169
Mortgage-backed securities12 (MBS)
1069
Total SOMA securities holdings
2009
Billions of dollars
10
11
12
Source: The Federal Reserve H.4.1.
Includes inflation compensation

Obligations of Fannie Mae, Freddie Mac, and Federal Home Loan Banks
Securities guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae.
16
Up until November 25th, 2008, the SOMA was only composed of U.S. treasury securities. To help reduce the cost and increase the availability of credit for the purchase of
houses, on November 25, 2008, the Federal Reserve announced (Monetary press release) that it would buy up to $1.5 trillion direct obligations of Fannie Mae, Freddie
Mac, and the Federal Home Loan Banks, and up to $200 billion MBS guaranteed by
Fannie Mae, Freddie Mac, and Ginnie Mae.
This is part of the numerous unorthodox actions taken by the Fed in order to keep financial stability in the wake of the financial turmoil. More explanations will be provided in
section III.
The Federal Reserve Bank of New York conducts open market operations for the Federal Reserve. The group that carries out the operations is commonly referred to as the
Open Market Trading Desk or the Desk. The Desk conducts business with U.S. securities dealers and with foreign official and international institutions that maintain accounts at the Federal Reserve Bank of New York. The dealers with which the Desk
transacts business are called primary dealers.
A Typical Day
Each weekday at around 7:30 in the morning a group of Federal Reserve staff members,
one at the Federal Reserve Bank of New York and a group at the Board of Governors in
Washington, prepare independent projections of the supply of and demand for Federal
Reserve balances. Upon completion of their forecasts, a telephone conference is set up
between staffs of the Board of Governors and the Federal Reserve Bank president. Special attention is paid to the federal fund market rate and the federal fund target rate. After assessment and consultation daily market operations are determined, the announcement is made to the market at 9:30 am.
2.3.4
The Greenspan Standards
Alan Greenspan was sworn in as Chairman of the Board of Governors of the Federal
Reserve System on August 11, 1987. He would be at the helm of the institutions for 18
17
years and become one of the most influential people in the world. The Maestro, as he
was referred to, has contributed greatly to the science of monetary policy.
Monetary policy as we know it today is relatively a new field. The first theories appeared in 1945 with the work of Clark Warburton, but we had to wait until 1979 for the
emergence of monetary policies, with the appointment of Paul Volker, a monetarist, as
President of the Federal Reserve. The result was the creation of the desired price stability. Since 1990, the classical form of monetarism has been questioned because of
events, which many economists have interpreted as being inexplicable in monetarist
terms, namely the decoupling of the money supply growth from inflation in the 1990s
and the failure of pure monetary policy to stimulate the economy in the 2001-2003. Interest rate were lowered to as low as 1% (June 25, 2003). Greenspan in his two-decade
reign set out new standards in the practice of monetary policy. What succeeds is Greenspans contribution to the science of monetary policy and an explanation of why they
matter so much.
2.3.4.1
Discretion rather than rules:
Modern thinking on monetary policy in clearly in favor of rules rather than discretionary policing13. The idea behind the theory is, after all what matters most is long-term
interest rate. Long-term interest rates are the backbone of most economical decision
private or public. Another argument in favor of rules is expectation management. If the
central banker adopts and follows a rule, it can steer the private sectors expectations in
a way that ensures that there will be some automatic stabilization of shocks 14. Barro and
Gordon (1983) even argue that period-by-period discretionary policies will lead to inflation.
Greenspan disagrees15 with these claims and prefers discretionary methods rather than
blindly follow preset rules. The maestro stated clearly his position at a symposium in
Jackson Hole where he states:
13
14
15
Kydland Prescott (1977) and Fisher (1990)

Woodford (1999)
Feldstein (2003), Fisher (2003), Yellen (2003) share greesnpans view
18
Some critics have argued that the Feds approach is too undisciplined, judgmental,
seemingly discretionary and difficult to explain. The Federal Reserve should some conclude, attempt to be more formal in its operations by tying its actions solely to prescriptions of a formula policy rule. That any approach along these lines would lead to an
improvement in economic performance, however, is highly doubtful
By looking at his tenure as chairmen, one cannot argue. The Maestro has controlled
inflation as well as Paul Volker his predecessor without rules and without serious precommitment.16 Greenspan officially and permanently dismissed the use of monetary
aggregates in 1993 as one of the key variables in the FOMC decision-making process.
He has also refuted the Phillips curve with a 6% natural rate. Studies such as Phelps
(1995), Stiglitz (1997) and Ball, Laurence & Robert Moffit (2001) have confirmed a
time varying natural rate of unemployment, which fosters a negative correlation with
productivity gains.
Greenspan never accepted that model with unchanging coefficient could describe the
U.S. economy adequately. He views the economy as in constant change and views the
central banker as always learning.
Greenspans unwillingness to follow any preset rule has made the Fed very flexible in
dealing with numerous crises throughout his reign17.
2.3.4.2
Real interest rate and the federal fund rate
Greenspans most important contribution to monetary policy is with no doubt his choice
of policy tool. Greenspan has favored the federal fund rate as the Feds main ammunition. By setting Fed fund rate, the Fed also indirectly sets real federal fund rates. This is
possible due to the slow moving nature of expected inflation (e). When the FOMC sets
the federal fund rate (i) it also sets the real one (r).
r = i e
16
17
The Feds press releases in which it would write: for a considerable period, at a pace that is likely to
be measured serving as weak Pre-commitment
Greenspan (2004) p 38
19
The real federal fund rate is then compared to the neutral real rate (r*). The deviation of
the federal fund rate (r) is calculated as follow.
r= r-r*
The concept of neutral real rate was first used by Wicksell (1898), but then, he called it
the natural interest rate. In Keynesian terms it refers to the interest rate that will result in
an output gap equal to zero, therefore the difference between r and r* can be viewed as
an indicator of the stance of monetary policy18.
Just like the natural rate of unemployment, there are many ways to calculate the natural
real rate of interest. Blinder (1998) proposes a rate at which inflation neither rises nor
falls.
By asserting the Federal fund rate as the main policy tools Greenspan has set a standard
that is currently used by almost every central banker around the world.
2.3.4.3
Fine-tuning:
Blinder and Reis (2005) define fine-tuning as using frequent small changes in the central banks instrument, as necessary, to try to hit the central banks targets fairly precisely
By the time, Alan Greenspan became chairman; fine-tuning had already been tossed out.
Lars Svensson (2001, p1) claimed, complex transmission mechanism and sluggishness
to affect the real economy prevented the use of fine-tuning. The Maestro through his
actions would prove that fine-tuning is an optimal way of conducting monetary policy.
Prior to June 1989, the FOMC under Greenspan changed the funds rate 27 times in less
than two years, only six of those changes where of 25 basis point. However, since June
1989, the FOMC has changed rates 68 times, and 51 of those changes were of 25 basis
points. Sixteen of the other 17 changes were of 50 basis points.
Greenspan had clear preferences for gradualism. This preference can be explained by
three reasons.
18
Woodford (1998)
20
1. Uncertainty: as stated by Lars Svensson, monetary policy isnt a perfect science

the transmission channels are complex, interconnected and interdependent. One
must add to that the lags. According to Kenneth N. Kuttner and Patricia C.
Mosser (2005) it takes about six to nine months for policies to start having an
impact on the real economy. During this period many things can happen thus
authorities are faced with the uncertainty of the state of the economy when their
actions start bearing fruit. Therefore it is preferable to move in small steps
toward policy goals.
2. Interest-rate smoothing: As previously stated almost all central bank use interest
rates as their main policy tool, thus it is preferable to move interest rate
gradually rather than abruptly. Large variations in interest rate will produce
large capital gains and losses that might increase market volatility. Woodford
(1999) argues that if policy maker can commit to a future path of interest in
response to shocks, the private sector will expect the bank to continue to move
interest rates in the same direction and thus adjust prices, offsetting those who
do not adjust.
1. U-turn Aversion: between policy implementation and the time for it takes for it
to take affect a lot can happen in an economy. The next course of action for the
authorities depends on the news that comes in. It is therefore preferable to adopt
gradualism rather than abrupt changes in interest rate. Suppose for instance
interest rates where set directly at the targeted level, it will require about six to
nine months for the effects to be felt. In the meantime thing can change in the
opposite direction19. In this case the central bank would have to make reversal in
policy. Such reversal will have a negative impact on the central banks
credibility. Greenspan states: If we are perceived to have tightened and then
have been compelled by market forces to quickly reverse, our reputation for
professionalism will suffer a severe blow.
Greenspan legacy as one of the worlds best central banker will carry on through his
standards. His two-decade reign has undeniably changed the face of U.S. monetary policy. An important fact about these standards is they were not invented by Greenspan he
19
A prime example is the financial crisis, in a matter of months the interbank market stated drying up.
See Angelo Baglioni (2009) Liquidity Crunch in the Interbank Market
21
has either introduced them or underlined there importance in monetary policy. This does
not take away any credit on his part for his brilliant career as chairmen of the Fed.
Other standards have been introduced by the maestro, but due to the debate surrounding
the righteousness of these standards, this paper has only taken into account the unanimous ones. A prime example of a controversial standard would be the bubble conundrum. For Greenspan, the Federal Reserve should not interfere with asset prices. He
reckon that bubble are hard to identify, and even if the Fed did successfully identify
one, the tools at its disposal are not surgical tools but a sledge hammer (the general level
of short term interest rates) which when used should be used with brute force to even
dent the bubble20. This in return would have a negative impact on the economy as a
whole to the bubble. In the case of the 1998-2000 dotcom bubble, how do you dissuade
investors who expect returns averaging 100% per annum? The answer is self-evident. A
shift in interest rates large enough to dissuade would have drastic consequences on the
economy.
Bernanke and Gertler (2001) study on the Fed and asset prices conclude that the Fed
should react indirectly to asset prices by responding to their effect on the inflation.
20
Greenspan (2008)
The financial Crisis
22
3 The financial Crisis

At the beginning of 2007, very few people had heard of the word Subprime. This was
about to change by the end of the year21 with the unraveling of the subprime crisis.
A subprime loan is a type of loan that is offered with a premium to people who would
not otherwise qualify for loan via regular credit channels. This concept was extended to
mortgages. When a borrower applies for a mortgage, the lender checks the borrowers
ability to payback le loan, via credit reporting agencies. The assessment of the borrowers riskiness is referred to as underwriting the loan. Subprime mortgages are handed
out to people, who do not qualify for prime mortgages.
In the 90s the subprime mortgage represented, 5% ($35 billion) of total mortgages in
the U.S., and by 2005, it had jumped to 20% ($600 billion) of total mortgage22. In 2006,
the percentage of defaults started to rise in this particular segment, and would trigger
what would be called the subprime crisis. The subprime crisis would contaminate to the
whole U.S. financial sector and spread to the world to give birth to the global financial
crisis.
How has trouble in a $600 billion market managed end up triggering a global recession
and costing up to $7.7 trillion and wipe out 14% market capitalization?
What follows is a thorough analysis of the unraveling of the crisis, how has it spread out
and how policy makers have dealt with it. The analysis will be limited to the United
States.
3.1 How the system set up the crisis

A combination of macroeconomic and microeconomic factors set the founding blocks
of the crisis.
21
22
The term Subprime was mentioned in 6000 articles in 2006 and 162000 times in 2007 according to
Factiva (Business information and research tool owned by the Dow Jones)
Source, the 2007 Mortgage Market Statistical Annual
3.1.1
3.1.1.1
23
Macroeconomic Imbalance
The United States Current Deficit
The U.S. current deficit is our starting point in our analysis. In 1991, the U.S. posted its
first current surplus in 8 years 0.7% of GDP. Ever since Uncle Sam grew a current deficit of $811 billion (6.1%) by 2006; the biggest deficit ever contracted by a country. The
current account represents the net result of saving and investments. The U.S. savings
rate had sharply fallen from 7.5% in 1991 to 1.9% at the end of 2006. The difference
was made up by borrowing from surplus countries such as Germany, China and OPEP
countries. By 2005, the U.S. absorbed 80 percent of international saving that crossed
borders.
Ben Bernanke (2005) explains that the problem emanated from the rest of the world and
that the U.S. imbalance is a reaction to it. Bernanke states that, the growing surplus generated by oil exporting countries, countries with an aging population (Germany, Japan)
and countries with huge trade surpluses( China, South Korea.) are the causes of the
U.S. deficit. Bernanke refers to the excess saving outside the U.S. as the saving glut.
These countries do not have capital markets capable to absorb the surplus; therefore,
they turn to the U.S., which has the deepest and liquid markets in the world23. The U.S.
reacted as a magnet to foreign capital. This surplus of demand gave rise in asset prices
in the 90s. Higher stock market wealth, stimulated Americans to consume more thus
save less and less while contracting more debt.
Bernankes theory provides a suitable external explanation to the deficit. Internal causes
have to also be factored in. The U.S. budget deficit kept growing at the same pace as the
current deficit, giving birth to the Twin deficit hypothesis.
However, the sparks accelerating the imbalances came after the burst of the dotcom
bubble in 2000. We thus examine the role of monetary policy during the Greenspan era
3.1.1.2
Liquidity
In January 2001, the technology bubble, which had built up over the past 5 years, went
burst. The tech wreck threatened to send the economy into recession. Staying faithful to
23
US treasuries are the most liquid markets in the world.
24
his standards, Ride the booms and cushion the bursts, Greenspan lowered interest
rate in order to keep the economy afloat. Shortly afterwards the September 11 events
occurred and sent shockwaves throughout the system. The Fed, determined to avoid a
Japan style deflation, which cost Japan a decades worth of growth, began a series of
rate cuts in order to provide liquidity to the market to fend of the deflationary pressure
and keep the economy form falling into a painful recession. After 13 rate cuts, as
shown in Table 3, the Fed funds stood at 1% in June 2003 from a high of 6 percent in
January 2001. Rates would be maintained at 1% for a year.
Extremely low interest rate helped a highly leveraged indebted corporate America restructure its balance sheets and navigate through the storm. Low rates also helped created a new imbalance, this time in the housing market. Low interest rates implied low
mortgage rates leading to a boom in mortgages. This had two implications: 1) the excess
demand for housing lifted house prices and directly increased household net worth. As
Americans, felt richer they started consuming there newly acquired wealth. Consumption soared to more than 70 percent of GDP and saving fell to as low as 1.9 percent, this
led to more and more imports, widening the current account deficit. 2) As mortgage
lending soared the market began to saturate, so lender turned to more risky customers
with subprime mortgaged increasing demand in an already buyers market. Mortgage
companies also started to pop up like mushrooms. This was made easy because lending
terms were eased by banks24.
Low interest rates are not the only culprits in the housing boom; legislative measures set
the bedrock for the boom, which started well before 2001 as shown in figure 2. Congress pushed Freddie Mac and Fannie Mae, two government sponsored enterprises
(GSE), to increase their purchase of mortgages going to low and moderate income borrowers. In 1996, specific targets were given to our two GSEs: 42 percent of mortgage
refinancing was to go to borrowers with income below the median income of their area.
The figure rose to 50 and 52 percent respectively for 2000 and 2002. Meeting targets
was easy because Freddie Mac and Fannie Mae both enjoyed government backings;
they were thus able to borrow at very low rates. By 2006, the two enterprises had
bought billions of subprime mortgages.
24
Further explanation on this is given in 2.1.2.1
25
Table 3: Target federal funds rate, 2000-2004.
Date
Increase
Decrease
Level (percent)
2000
16-May
50
6.5
50
50
50
50
50
25
25
50
50
50
6
5.5
5
4.5
4
3.75
3.5
3
2.5
2
25
1.75
2002
6-Nov
50
1.25
2003
25-Jun
25
2004
30-Jun
25
2001
3-Jan
31-Jan
20-Mar
18-Apr
15-May
27-Jun
21-Aug
17-Sep
2-Oct
6-Nov
11-Dec
1.25
Source: The Federal Reserve Board.
The Feds policy indirectly increased world liquidity via two channels: 1) increasing
foreign exchange reserves in net exporting countries. With American consumption at its
highest, Asian countries enjoyed a boom in export to the U.S.. They accumulated huge
amounts of dollar reserves. Leading the pack, China and Japan saw their reserves grow
respectively from $212.2 and $387.7 billion in 2001 to $ 1,104.7 and $880 billion in
2007. Some of this money found its way back in the U.S. through financial markets,
adding more liquidity to the U.S. market thus driving prices higher. 2) Countries such as
China and most Asian countries have their currency pegged to the dollar; they indirectly
imported Uncle Sams expansionary policies resulting in an increase in domestic liquidity.
Why wasnt this increase in global liquidity translated into inflation? The 80s hawkish
monetary policies proved successful, average inflation of OECD members was reduced
from 15 percent to less than 5 percent. Volatility in inflation had also reduced considerably. This was coupled with the great moderation a decrease in GDP volatility
throughout the world and fierce competition which drove prices down (especially
26
among Asian countries). Monetary institutions had the faith of the private sector in
keeping low inflation. The result was low inflation expectation in the short run and medium run.
Figure 2: S&P/CaseShiller U.S. national home price index.
Source: Standard & Poors
3.1.2
Microeconomic shakiness
Macroeconomic imbalance gave ground to microeconomic shakiness in the financial

sector and gave birth to excessive risk taking and complex financial products.
3.1.2.1
Quest for higher return
After the dotcom bubble burst, panic could be read all over the market. In such time
investor run for in fixed income markets, government bonds, especially the U.S. treasury market. This situation is referred to as flight to safety; investors weather the storm
by taking refuge in fixed income security. Treasury securities offered security but the
returns were miserable consequence of historically low interest rates. With global liquidity at its highest in decades, banks held excess liquidity and face heavy competition
from alternative funds (private equity firm and hedge funds) that generated double-digit
27
returns. Their returns differed from others due to their high leverage ratios. With interest
rates so low, this did not constitute a problem in the short term. Alternative fund started
poking investor from traditional investment banks who were not able to offer the same
returns. In a need to bolster returns investment banks began to be more and more creative and started taking more and more risk. This is the beginning of an unprecedented
boon in complex financial products. Traditional banks also started to soften lending
term in order to increase returns, leading to a boom in mortgage lending. For regulatory
purposes, an increase in loans needed to be couple with an increase in capital. Banks
and lenders have found a brilliant way to go around this: Securitization
3.1.2.2
Securitization
Securitization contrary to common believes is not a new practice, it has been used for
over half a century. The first such operations were completed by GSE (Freddie Mac and
Fannie Mae). Securitization is a financial technique used to transform traditional illiquid
bank loan into marketable securities. Securitization only concerned mortgages at that
time and were referred to as mortgage-backed securities (MBS).
Thanks to financial innovation, securitization would be extended to all type of credits
and GSEs would no longer hold the monopoly. Asset backed (ABS) securities are securities backed by a pool of loans other than mortgages (Consumer credit, auto credit
etc...) Collateral debt obligations (CDO) are securities backed by a pool of marketable
loans (Bonds, commercial papers). The returns of the securities are guaranteed but the
interest paid on the loans.
Securitization transfers the credit risk from the lenders to the markets, it takes the loans
of the lenders balance sheet therefore no need to increase capital and even better, they
could give out more loans. Securitization has developed very quickly; total securitized
market was worth $10 trillion representing 40 percent of the bond market25 at its peak in
2006. Securities were sold by different category of risk meaning different type of returns.
25
Excluding US treasuries
28
The riskiness of the new securities was accessed by rating agencies. Based on the ratings assigned to each tranche of security, their valuations are determined. Senior tranches were the most secure and rated AAA/Aaa, then came mezzanine, with a little more
risk and rated BBB/Bbb and equity tranches the riskiest of them all with non-predefined
retunes and with a high-expected return.
Securitization expanded so rapidly, institutions started buying securitizes securities on
the market. It became so complex, bankers did not know who had what, hence werent
able to access the risk related to these securities. This did not matter mush to them because they had they had bling faith in the rating assigned by rating agencies and they
believed that the risk had been spread out throughout the markets.
3.2 The meltdown

The previous subsection explained the frail built up of the system. The frail system was
a castle of card. All was well until on component moved or defected, triggering a mass
domino effect.
The perennity of the system was based on two pillars. The first pillar was stable and low
interest rates. This allowed interest paid on debt to be low. It also allowed lenders to be
more expansionists. The second pillar is a direct consequence of the first, housing prices
should continue to rise, hence making household richer and entitling them to borrow
more with their houses as collateral.
Pillar 1 was brought down with the tightening of monetary policy for fear of rising inflation. Interest rate progressively climbed from 1 percent to 5.25 percent between 2001
and 2006. The rise in Fed fund rates constitutes the triggering of the domino effect that
led to frenzy in the markets.
With a high volume of adjustable mortgages, household felt the pinch when interest
rates their upward march. This increased the delinquency rate on mortgage payment as
shown in figure 3.
29
Figure 3: prime rate mortgages Vs Adjustable rate mortgage delinquency rates
Source: Observatoire Franais des Conjonctures Economiques(OFCE)
A rise in delinquency rate meant that cash flows to holders of MBSs were not guaranteed. This in turn prompted rating agencies to reevaluate their rating on MBSs. The
dominos effect was set in motion.
June 15th
Moodys degrade 131MBS from AAA to BBB and put

250 more on their watch list
th
July 10
S&P put $7.3 billion worth of on a negative watch list and

Moodys degrades $5 billion MBSs from AAA to BBB
July 11th
Moodys puts 184 tranches of TGC Homes MBS on

negative watch list
July 26th
Sales of new home fell almost 6.6 percent compared to a

year earlier.
With interest rate going up less and less borrowers were able to shoulder the burden of
the monthly mortgage rate. By end 2007 there was a serious gap between offer and demand for new houses in favor of the former. This drove house prices down destroying
the second pillar of the system and gave way to the free fall. Figure 5 explains the series
of chain reactions that followed.
30
Figure 4: Subprime Mortgage Crisis
Source: Observatoire Franais des Conjonctures Economiques(OFCE)
Excess housing put downward pressure on prices. This decreased households net
wealth and made it hard for refinancing under favorable terms. Monthly mortgage rate
increased and lower end borrowers were not able to meet repayments deadlines. This in
turn decreased the cash flow to securitized asset, therefore prompting rating agencies to
lower rating. A lower rating highlighted more risk, which implied a higher rate of returns. This drove the prices drown. Banks bought the AAA rated securities and used
them as collateral in there balance. With most of the MBSs downgrade, they did not
meet the standards of collateral imposed by Basel II. Banks had to recapitalize in order
to satisfy regulation.
At this point, none of the major financial institutions knew what the length of their exposure to these toxic assets. An accelerator of the downfall was the mark-to-market or
fair value accounting. This obliged institutions to value certain categories of asset (this
included MBS, ABS and CDO) held on their balance sheets at market value. During the
crisis this was a huge problem, there was no market for these securities because no one
31
was buying them and their prices just kept on collapsing, prompting another series of
write-downs and recapitalization.
July 31st
Bear Stearns announces it will close two of its hedge

funds, which had lost 90 percent of their holdings
August
Subprime woes go global, Frances BNP Paribas announces it is unable to value the assets held by its hedge
funds, other European big banks follow shortly.
September 13th
Northern Rock a British bank requests emergency funds

from Band of England and is victim of a bank run. To call
people down the government increased the guarantee on
deposits from 50 000 to 100 000 pounds.
September 18th
The Fed cuts interest rates by 50 basis points to 5.75 percent.
2008
March 14th
Bears Stearns is bailed out, by a fire sale to JP Morgan

Chase for $10 per share. Two month earlier the bank traded at $172.
September 15th
Lehman brothers files for bankruptcy, the largest bankruptcy in U.S. corporate history. The bankruptcy-spooked
market who never thought the government would let such
a big company fail. Bank of America buys Merrill Lynch
September 17th
The U.S. Treasury gives American International Group

(AIG), the world largest insurance company, an $85 billion emergency lifeline.
September 19th
Henry Paulson then Treasury Secretary unveils a $700 billion rescue plan called Troubled Assets Relief Program, or
TARP.
32
September 21st
The last two major investment banks on Wall Street, convert to bank holding companies in order to tap in the Feds
emergency funds
October 1st
Congress approved Paulsons $700 billion rescue package
The rapidity of the contagions was due to the sophistication of new financial products,
the mispricing of risk, and the inability to evaluate holdings. Nobody knew what others
exposures were and this triggered a confidence crisis. Banks were unwilling to lend to
each other even on the shortest term, overnight. The interbank market dried up. What
had started out as a subprime crisis due to over liquidity had mutated in to a confidence
and liquidity crisis.
The road to recession come through the credit channel, banks in urgently need to bolster
their balance sheet, simply stopped giving out credits. This has the same effect of to
cash strap business that was not able to roll over their debts. This in response triggered
massif layoffs. Fewer workers meant less disposable income as a whole thus less consumption. Consumption is the main propeller of the U.S. economy, a steep drop in consumption led to the economy to a grinding halt, which led to more layoffs thus lowering
consumption, and the vicious circle goes on.
3.3 Policy response

The Fed has been very aggressive in combatting the crisis and to avoid total market
meltdown. The Feds main priority during the crisis was financial stability. Ben
Bernanke, widely renowned as one of the best experts of the great depression, was the
right man for the job. The Fed used convention and unconventional methods within its
legal limits to ensure stability. The conventional methods are the usual rate cutes
FOMC meeting. The rate cut are displayed in Table 4.
33
Table 4: Target federal funds rate cuts in response to the crisis
Date
Increase
Decrease
Level (percent)
18-Sep
31-Oct
11-Dec
50
25
25
4.75
4.5
4.25
22-Jan
30-Jan
18-Mar
30-Apr
8-Oct
29-Oct
16-Dec
75
50
75
25
50
50
75100
3.5
3
2.25
2
1.5
1
00.25
2007
2008
Source: The Federal Reserve Board.
In the mist of the crisis interest rate cuts were not enough, the Fed relied on nonconventional tool to shore up market with liquidity.
Term Auction Facility (TAF)26: Banks reluctant to use the discount window. A use of
the discount window would trigger a negative signal to the market. The discount window failed to reduce the spread in the interbank market. The FOMC announced it would
auction predetermined amount of liquidity. The Fed implements the TAF in December
2007. Auctions were fortnightly and initially in small amounts, $20, $30, and $50 billion for a period of 28 or 35 days. Any of the 7,000 plus commercial banks could participate in the auction. The minimum bid rate was set according to the Fed fund target rate.
Rescue of Bear Sterns: This is the first time the broker have been rescue since the great
depression. Face with liquidity problems Bear Sterns was bought March 17 by JP Morgan Chase & Co, then U.S. 3rd largest bank by market cap, for $240 million27 a tenth of
its value. The Fed provided financing for the transaction, and pledged to support $30
billion worth of Bear Sterns assets.
Term Securities Lending Facility (TSLF): The TAF had fail to significantly impact the
spread between the three-month LIBOR and the three-month expected federal funds.
The Fed then came up with the TSLF. The basic idea is as follow. In regular time, insti26
For further details Cf The Federal Reserves weekly balance reports Term Auction Facility
27
10 per share, the company was worth less than its headquarters it owned.
34
tutions would short sell treasury securities to each other with the prospect of buying it
on the market before the delivery date. This would represent in some way a short term
financing for the shorting firm. If the seller was not able to buy the treasury in the market, it could go to the Fed, and borrow the security for 24h. The procedure was change
in three ways to give birth to the TSLF program. First, the loan time was extended to 28
days. Second, the collaterals used were broadened; AAA mortgage-backed securities
were accepted as long as they were not on downgrade watch. Third, the Fed was willing
to loan up to $200 billion through the TSLF.
Primary Dealer Credit Facility (PDCF): Primary dealers are banks and or security
brokers who are allowed to trade directly with the Fed. Nineteen of these dealers are not
bank thus unable to use the Feds discount window. The PDCF allows these dealers to
use the discount window.
With interest rates barely above zero, the fed only had unconventional method at its
disposal. Ben Bernanke knowledge of the great depression and the inefficiency of the
Japanese decade zero rate policy proved handy in stabilizing the financial system on the
brinks of collapse. The following section will be an empirical analysis of the Federal
Fund rate using the simple Taylor rule in order to determine 1) can the Fed funds in
time of crisis be guided by a simple rule and 2) how will the crisis impact future monetary policy in the short and medium run.
Empirical Analysis
35
4 Empirical Analysis
This section is devoted to the analysis of the U.S. Federal Funds from 1998 to 2009.
The methodology and an ample explanation of the data are supplied prior to the results
of the empirical analysis.
4.1
Methodology and Data
The best predictor of U.S. federal fund Rates is the simple Taylor rule, therefore our
analysis will evolve around this simple rule. The study period is from 1988 to 2009 and
encloses three major recessions: 1) the 90s saving and loan crisis 2) the tech recession
also known as the dotcom recession and 3) the financial crisis. The Feds dual mandate
obliges it to take into account negative fluctuations of output thus in order to identify
how the fed responds to such events, a separate analyses will be conducted on the three
recession periods.
The analysis will be of two stages.
Stage 1
We begin by calculating the federal fund rates according to a modified Taylor rule.
Modifications brought to the rule are the results from critics emanating from Orphenides (1997). Taylors original calculations use revised data, which were not available to
the FOMC at the time of the meetings. To go around this problem we use unemployment gap to replace the output gap. The Consumer Price index (CPI) excluding food
and energy is used in place of inflation.
For comparative reason we use two different modified Taylor rule:
One without Okuns law, referred from now on as T1
T1
FFt = rt + t + 0.5 (ut* - ut) + 0.5(CPI - *)
Empirical Analysis
36
with the Okuns law referred to as T2
T2
FFt = rt + t + 0.5 Okun (ut* - ut) + 0.5(CPI - *)
ut*: represents the natural rate of unemployment or the on accelerating inflation rate of
unemployment: NAIRU. The NAIRU is subject to changes over the long run, and is
positively correlated with technological progress. The NAIRU rates used are estimated
by Ball Mankiw (2002) and are displayed in table 5.
Table 5: NAIRU rates
Time Period
1988--1992
1992-1999
1999-2009
ut*
6%
5.40%
5%
ut: is the monthly unemployment rate published by the Bureau of labor and Statistics
(BLS)
(ut* - ut): is defined as the unemployment gap
Okun: Represents the relationship between Unemployment and GDP. Attfield & Silverstone (1997) estimate the relationship to be of the order of three (3) for the U.S. economy. An increase of 1 percent in the unemployment rate will translate into a 3 percent
reduction of GDP
CPI: CPI excluding energy and food
*: Represent the Feds inflation target rate: two (2)
(t - *): Inflation gap
Stage 2:
Stage 2 is an OLS regression of the modified Taylor rule to which we add two independent variables: U.S. industrial production index and the Personal consumption expenditure survey index. The former is a front-runner indicator of future economic activ-
Empirical Analysis
37
ity. The later account for approximately 64 percent28 of GDP in the U.S., and is an indicator of the private sectors expectation on the future path of the economy. When consumers have a bleak picture of the future they tend to reduce their consumption and save
more. A first regression is conducted on the whole data. The second is a series of regressions, all the same as the first but conducted solely on recession periods to in order
to identify changes in the coefficient of independent variables.
The results of stage 1&2 are pooled together and conclusions are drawn from order to
fulfill the purpose of this paper is set out for.
4.2
Analysis
Analysis starts with descriptive statistics of the data29 set: the effective federal fund rate
(FF) and the rates given by the modified Taylor rule without Okuns law, and with
okuns law.
Table 6:Descriptive Statistics
N
Minimum
Maximum
Mean
Std. Deviation
Variance
FF
264
0,12
9,81
4,4298
2,31376
5,353
Taylor Rule
264
0,75
9,40
5,1049
1,73867
3,023
Taylor rule-okun
264
-4,10
9,70
4,7614
2,58223
6,668
The data is composed of 264 observations representing the number of month in our period of study. The means are relatively close to 4%, which would be the federal fund
rate under the Taylor rule if inflation gap and unemployment gap was both equal to zero. This reflects the central bankers role in maintaining inflation at relatively low rates.
Average inflation throughout the period was 2.85%...
In order to compare the likelihood of our two Taylor induced data set with the effective
fund rate, we conduct a paired T Test. A paired T test calculates the difference between
two variables for each observation and tests to see if the average difference is significantly different from zero. We want to see how well our data replicates the effective
rates. Results are displayed in table 7&8
28
29
Average over the study period, source BEA

The data set is found in Appendix A
Empirical Analysis
38
Table 7: Paired Correlations FF&T1, FF&T2

N
Correlation
Sig.
264
,844
,000
264
,882
,000
Pair 1
FF target rate & Taylor Rule (T1)
Pair 2
FF target rate & Taylor rule-okun
(T2)
Table 8: Paired T-Test FF&T1, FF&T2

Paired Differences
95% Confidence Interval of the
Std. Devia-
Std. Error
tion
Mean
Sig. (2t
df
Difference
Mean
tailed)
Lower
Upper
FF target rate Pair 1
-,67511
1,25797
,07742
-,82756
-,52267
-8,720
263
,006
-,33155
1,21930
,07504
-,47931
-,18379
-4,418
263
,018
Taylor Rule
FF target rate Pair 2
Taylor rule-okun
T1 and T2 have strong positive correlations, with a slight advantage for T2. T1 and tT2
estimate federal fund rate with an accuracy of 84% and 88% respectively. The Sig. (2tailed) are both less than 0.5 implying significance differences between T1&FF and
between T2&FF. The following chart provides a visualization of the three variables.
Empirical Analysis
39
Figure 5: FF,T1&T2 plot
Visual observation shows in times of recession T1 and T2 have difficulties predicting

the fund rates. Between 1988 and 2009, the U.S. has had 3 recessions
1990: loan and saving crisis (Q2 1990- Q3 1992)
2000: tech recession (Q3 2000-Q2 2002)
2008; financial crisis (Q2 2008- Q42009
The Feds dual mandate obliges it to respond to economic down-term, thus giving more
importance to unemployment gap in regards to inflation gap. In recession, inflation
fears are replaced by deflationary fears. This is interpreted inT1& T2 by giving more
weight to unemployment gap. Dichotomy give use the following weights 0.6 and 0.4 for
unemployment gap and inflation gap respectively.
By implementing the changes and conducting independent analyses on recession periods, we observe improvement in the paired T test for all three-recession periods from
Empirical Analysis
40
66% to 83% for the 90s recession, 73% to 87% for the Tech recession and finally 76%
to 92% for the financial crisis30.
To confirm finding from stage 1, the same procedure is used with regression analysis.
We start by a simple linear regression of the data set then we apply the same to the three
recession periods.
The removal method is applied in order to reduce the number of independent variable to
the strict a minimum.
The results are shown in the table 8&10.
Table 9: Entrer/Remove regression Model Summary

Model
R Square
Adjusted R Square
Std. Error of the Estimate
,894a
,800
,796
1,02874
Durbin-Watson
Table 10 : Coefficientsa
Unstandardized Coeffi-
Standardized
Collinearity StatisCorrelations
cients
Coefficients
Model
tics
t
Sig.
Zero-
Std. Error
Beta
Partial
Part Tolerance
VIF
order
(Constant)
3,300
,150
(ut* - ut)
1,093
,057
(CPI - *)
1,406
22,034
,000
,555
19,295
,000
,628
,770
,541
,950
1,053
,063
,633
22,382
,000
,683
,814
,628
,983
1,017
,145
,099
,043
1,453
,147
,104
,091
,041
,890
1,124
,083
,022
,063
2,084
,038
,230
,129
,058
,871
1,148
U.S. Industrial
production Growth
Personal consumption expenditures
Growth
a.
Dependent Variable: FF target rate
The best model uses all four independent variables: unemployment gap, inflation gap,
the U.S. industrial production (IP), and personal consumption expenditure (PCE). The
model specifications are:
30
Paired T test and graphs for each crisis period are in appendix B
Empirical Analysis
41
FFt =3.3+ 0.555 (ut* - ut) + 0.633(CPI - *) +0.04 IP+ 0.63 PCE+ t
The model has a R2 of 80%, which means our model explain 80% of the changes in federal fund rates. The variance inflation factors (VIF) are well above there tolerence level
(0.5) which exclud multicollinearity.
Results of independant analysis of recession periods are captured in the following
tables.
Table 11: Model Summary, recession periods

Model
R Square
Adjusted R Square
Std. Error of the Estimate
90
,816
,667
,640
,99548
Dotcom
,974
,948
,937
,48340
Fin crisis
,970
,940
,920
,24138
Table 12: Coefficients

Standardized CoeffiUnstandardized Coefficients
cients
Model
90
Sig.
,074
,941
Std. Error
Beta
(Constant)
,087
1,166
(CPI - *)
,036
,187
,027
,194
,848
(ut* - ut)
2,149
,380
,800
1,656
,070
(Constant)
7,734
3,774
2,049
,055
(CPI - *)
,943
,833
,066
-1,132
,272
(ut* - ut)
,868
,055
,830
5,699
,143
U.S. Industrial production
,243
,267
,066
,908
,375
6,374E-5
,009
,018
,306
,763
(Constant)
1,347
,295
4,567
,000
(CPI - *)
,165
,112
,308
1,477
,162
(ut* - ut)
1,504
,478
,657
3,150
,047
Dotco`124m
Personal consumption
expenditures
Fin Crisis
a. Dependent Variable: FF target rate
The result of independent crisis period study confirms our results in stage 1.
Empirical Analysis
42
90s crisis: Only inflation and output gap are retained, the other variables are insignificant. Inflation gap explains only 27% of changes in FF down from 63% on the
other hand; unemployment gap explains 80% up from 62%.
Dotcom: All the variable are significant. The weight assigned to inflation gap
drops to 6% and unemployment gap rises to 83%. The very low weight assigned to inflation gap is a direct consequence of the bursting of the tech bubble, creating a deflationary choc. Inflation did not constitute a short-term threat; focus was put in restarting
the economy.
Financial Crisis: Here consumer expenditure and industrial production are excluded from the model, leaving only inflation and unemployment gap to explain 38%
and 65% of federal fund change respectively. Unemployment gap only explain 3% more
of changes in federal fund rates. As of December 2009 federal fund rated have been
fixed in the range of 0-0.25%, while economic conditions continue deteriorate suggesting further rate cuts. The fact is, rates cannot go any lower, which prompted the Fed to
take unconventional measure as explained in 3.3. This is reflected in figure 5.
4.3
Results
The modified Taylor rules represent a simple and efficient predictor of federal fund rate.
With a paired correlation ratio largely above 80% in all the cases studied and an average
standard deviation of 1.22%, the modified Taylor rule is a guide for future monetary
policy. The standard deviation is just too high, a 1.22% deviation in federal fund rate
has significant ramification for the economy. Therefore, the modified simple rule is not
a rule of thumb but a tool shedding light on the discretionary policies of the FOMC.
The rule presents numerous advantages. It can be easily used to predict future trends in
interest rate. The data used in its calculation is accessible to the common individual.
The rule does not rely on historical data; it is a forward-looking rule. It is even more
valuable in predicting interest rate of countries such as Sweden and England where central banks focus solely on inflation.
Empirical study confirms our finding. We proceeded to add two independent variables,
industrial production index (IP) and personal consumption expenditure index (PCE).
These variables are key economic indicators of future economic prospect. As the model
Empirical Analysis
43
represented bellow, shows IP and PCE explain less than 1 % of the changes in federal
fund rate; whereas unemployment and inflation gap explain roughly 55% and 63% of
fluctuations respectively.
FFt =3.3+ 0.555 (ut* - ut) + 0.633(CPI - *) +0.04 IP+ 0.63 PCE+ t 31
By conducting the same analysis to the recession period, we find that IP and PCE are
excluded from the model during the 90s and financial crisis recession. The model specifications are given bellow:
90s
FFt =0.87+ 0.80 (ut* - ut) + 0.27(CPI - *) + t
Dotcom
FFt =7.73+ 0.83 (ut* - ut) + 0.66(CPI - *) +0.66 IP+ 0.18 PCE+t
Fin Crisis
FFt =1.34+ 0.65 (ut* - ut) + 0.30(CPI - *) + t
In times of crisis, the analysis shows on average that the unemployment gap explains
76% of changes in federal funds. This also confirms our previous results. Due to its dual
mandate, the Fed in times of recession has to stimulate the economy to keep GDP on a
sustainable and non-inflationary trend, which translates into rate cuts, which in turn eases credit and floods the economy with liquidity.
Now that light has been shed on how the FOMC sets interest rates, combining it with
our theoretical framework, we are thus able to determine the effects of the global financial crisis on the future monetary policies.
With current interest rate in between 0-0.25%, the only way rate can go is up, the question reside in when and how fast will they rise. In normal conditions, we would turn to
our modified Taylor rule for guidance. However, with unemployment above 9% and
inflation at 2.1 % the rule would suggest rate cuts, which is not an option. In post-
31
Model for the whole period of study
Empirical Analysis
44
recession periods in our data set, a tradeoff can be observed between inflation and unemployment. Whoever this is unlikely to occur in the present case, and for several reasons: 1) the severity of the recession has created many bankruptcies and restructuring
leaving fewer companies to hire people. 2) Recessions are usually followed by waves of
consolidation in numerous industries (Berger & Humphrey, 1995), and consolidation is
synonym to layoffs. 3) inflation will pick up speed faster than usually because of commodities, demand from emerging countries such as China and India who have barely
felt the crisis have kept commodity prices from falling too much. The emergence of
OECD countries from recession will put upward pressure on prices. Even though the
Fed uses core inflation32, high commodity prices will create imported inflation. 4) Deficits restrict the government in using fiscal policy as a stimulating tool.
To combat the rise of inflation, without sending the convalescent economy back into
recession, monetary authorities will proceed as follow:
-
Eliminate special facilities granted during the crisis in order to secure financial
stability. These facilities provided liquidity to the market during the crisis. It is
unclear which facilities will go first or whether they will be gradually or abruptly ceased but this will mainly depend on the strength of the recovery and the stability of financial markets.
The fed will proceed to cleaning it balance sheet of CDOs, MBS, and ABSs
bought during the crisis in order prevent these markets from collapsing. The sale
of these securities will act an open market operation in which the monetary institution by selling these securities proceed to reduce the overall liquidity in the
economy. A reduction of liquidity will help slow down inflation.
When the two first steps are completed, the Fed will proceed in incremental interest rate hikes to fend off inflation. At this point if the economy is, still week
or growing significantly below its potential rate the Fed will accept a short-term
tradeoff between inflation and employment in favor of the later.
Once the Feds balance sheet is back to pre-crisis status quo, special lending facilities have been ceased, then and only then, it may start rising interest rates.
When this happen the modified Taylor rule can be used to guide us on future
monetary policy trends.
32
Inflation excluding food and energy
Empirical Analysis
45
The long run effect of the crisis on monetary policy will reside in the dual mandate of
the Fed. Expected to be the lender of last resort and being able to stabilize market in
extreme situations, the Fed will have to be creative in combatting new crisis ahead. The
panoply of unconventional tool used during the crisis will in the future judged as conventional in times of financial instability. This will increase moral hazard and make the
central banks task harder. The private sector will have overconfidence in the institution
and expect the Fed to be able to ensure financial stability in the worst of scenarios. To
ensure moral hazard does not spread out of control the Fed would have to send a clear
message to financial market; such message could be to let a significantly important institution fail.
Conclusion
46
Conclusion
Monetary policy came back into the spotlight thanks to the years of stagflation.
Monetary policy is now regarded a one of the most importance policy tool at a governments disposal. Monetary policy is not an exact science far from that. The unpredictably
of the economy, the crisis, and the mitigated effects of policies make it hard to be able
to fit monetary policy in a box. This work is a hybrid analysis between theory and practice in order to determine how the biggest crisis since the great depression will affect the
central banks job in the future. Three major results are to be retained; Federal fund
rates are the Feds main policing tool and are among the most watched indicator in the
world. The Taylor rule describes changes in federal fund rate. It is only to be used for
guidance regarding federal fund rate, it is in no way a tool for determining future rates.
2) The Feds focus changes as the economy enters different cycles. In bad times, it focuses on keeping the economy from dipping into recession or makes the recession as
short as possible. The size of focus depends largely on the size of shocks to Uncle
Sams economy. 3) There is no guidebook for monetary policy, when interest rates are
at the vicinity of zero the central banker has to be creative and come up with solutions
in order to tackle le problem. This was the case with the financial crisis. Timing is of
essence, leaving rates too low for too long of too high has dire consequences for the
economy. Unless the federal fund rate is at zero, the Taylor rule is the best predictor of
future policies.
With the globalization and interconnection of economies throughout financial markets,
the Fed will have to take into account shocks outside its jurisdiction. Future studies
could be conducted to determine the impact of external shocks on the U.S. monetary
policy, determine the channels in which they affect policies. An interesting topic would
also be the impact of financial market on monetary policy.
References
47
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Appendix
Appendix A
Table 13: Data Set 1

Time
1/1/1988
2/1/1988
3/1/1988
4/1/1988
5/1/1988
6/1/1988
7/1/1988
8/1/1988
9/1/1988
10/1/1988
11/1/1988
12/1/1988
1/1/1989
2/1/1989
3/1/1989
4/1/1989
5/1/1989
6/1/1989
7/1/1989
8/1/1989
9/1/1989
10/1/1989
11/1/1989
12/1/1989
1/1/1990
2/1/1990
3/1/1990
4/1/1990
5/1/1990
6/1/1990
7/1/1990
ajusted UFF target rate U-Deviation

deviation
6.81
6.63
6.50
6.75
6.75
7.25
7.50
7.69
8.13
8.13
8.13
8.38
9.00
9.00
9.75
9.75
9.75
9.81
9.56
9.06
9.06
9.00
8.75
8.50
8.25
8.25
8.25
8.25
8.25
8.25
8.00
0.30
0.30
0.30
0.60
0.40
0.60
0.60
0.40
0.60
0.60
0.70
0.70
0.60
0.80
1.00
0.80
0.80
0.70
0.80
0.80
0.70
0.70
0.60
0.60
0.60
0.70
0.80
0.60
0.60
0.80
0.50
0.90
0.90
0.90
1.80
1.20
1.80
1.80
1.20
1.80
1.80
2.10
2.10
1.80
2.40
3.00
2.40
2.40
2.10
2.40
2.40
2.10
2.10
1.80
1.80
1.80
2.10
2.40
1.80
1.80
2.40
1.50
Personal
U.S. IndusInflation
consumption
R*+Inflation trial producDeviation
expenditures
tion Growth
Growth
2.30
2.30
2.40
2.30
2.30
2.50
2.50
2.40
2.40
2.50
2.40
2.70
2.60
2.80
2.70
2.60
2.60
2.50
2.60
2.40
2.30
2.30
2.40
2.40
2.40
2.60
2.90
2.80
2.80
2.90
3.00
6.30
6.30
6.40
6.30
6.30
6.50
6.50
6.40
6.40
6.50
6.40
6.70
6.60
6.80
6.70
6.60
6.60
6.50
6.60
6.40
6.30
6.30
6.40
6.40
6.40
6.60
6.90
6.80
6.80
6.90
7.00
0.13
0.19
0.55
-0.06
0.10
0.07
0.07
0.21
0.36
0.18
0.27
0.50
-0.63
-0.07
0.08
-0.59
0.13
-0.71
0.59
-0.14
-0.10
0.12
0.07
-0.06
0.92
0.31
-0.18
0.08
0.15
-0.13
1.53%
2.22%
1.74%
2.34%
2.15%
1.62%
2.10%
1.85%
2.51%
2.02%
1.64%
1.07%
1.64%
1.77%
1.91%
1.20%
1.96%
1.60%
1.41%
0.70%
1.76%
2.67%
2.33%
1.97%
1.22%
1.50%
1.52%
1.44%
1.90%
1.65%
1.21%
Appendix
Time
8/1/1990
9/1/1990
10/1/1990
11/1/1990
12/1/1990
1/1/1991
2/1/1991
3/1/1991
4/1/1991
5/1/1991
6/1/1991
7/1/1991
8/1/1991
9/1/1991
10/1/1991
11/1/1991
12/1/1991
1/1/1992
2/1/1992
3/1/1992
4/1/1992
5/1/1992
6/1/1992
7/1/1992
8/1/1992
9/1/1992
10/1/1992
11/1/1992
12/1/1992
1/1/1993
2/1/1993
3/1/1993
4/1/1993
5/1/1993
6/1/1993
7/1/1993
8/1/1993
9/1/1993
10/1/1993
11/1/1993
ii

deviation
8.00
8.00
7.75
7.50
7.00
6.75
6.25
6.00
5.75
5.75
5.75
5.75
5.50
5.25
5.00
4.75
4.50
4.00
4.00
4.00
3.75
3.75
3.75
3.25
3.25
3.00
3.00
3.00
3.00
3.00
3.00
3.00
3.00
3.00
3.00
3.00
3.00
3.00
3.00
3.00
0.30
0.10
0.10
-0.20
-0.30
-0.40
-0.60
-0.80
-0.70
-0.90
-0.90
-0.80
-0.90
-0.90
-1.00
-1.00
-1.30
-1.90
-2.00
-2.00
-2.00
-2.20
-2.40
-2.30
-2.20
-2.20
-1.90
-2.00
-2.00
-1.90
-1.70
-1.60
-1.70
-1.70
-1.60
-1.50
-1.40
-1.30
-1.40
-1.20
0.90
0.30
0.30
-0.60
-0.90
-1.20
-1.80
-2.40
-2.10
-2.70
-2.70
-2.40
-2.70
-2.70
-3.00
-3.00
-3.90
-5.70
-6.00
-6.00
-6.00
-6.60
-7.20
-6.90
-6.60
-6.60
-5.70
-6.00
-6.00
-5.70
-5.10
-4.80
-5.10
-5.10
-4.80
-4.50
-4.20
-3.90
-4.20
-3.60
Personal
U.S. IndusInflation
consumption
expenditures
tion Growth
Growth
3.50
3.50
3.30
3.30
3.20
3.60
3.60
3.20
3.10
3.10
3.00
2.80
2.60
2.50
2.40
2.50
2.40
1.90
1.80
1.90
1.90
1.80
1.80
1.70
1.50
1.30
1.50
1.40
1.30
1.50
1.60
1.40
1.50
1.40
1.30
1.20
1.30
1.20
1.00
1.10
7.50
7.50
7.30
7.30
7.20
7.60
7.60
7.20
7.10
7.10
7.00
6.80
6.60
6.50
6.40
6.50
6.40
5.90
5.80
5.90
5.90
5.80
5.80
5.70
5.50
5.30
5.50
5.40
5.30
5.50
5.60
5.40
5.50
5.40
5.30
5.20
5.30
5.20
5.00
5.10
0.14
0.01
-0.54
-0.77
-0.50
-0.52
-0.39
-0.43
0.20
0.46
0.72
0.16
0.15
0.70
-0.11
-0.17
-0.08
-0.42
0.61
0.64
0.35
0.42
0.21
0.57
-0.29
0.04
0.42
0.26
-0.12
0.73
0.08
-0.11
0.39
-0.10
-0.10
0.24
-0.07
0.42
0.59
0.29
0.59%
-0.17%
-0.58%
0.10%
1.53%
1.78%
1.70%
0.65%
1.45%
0.87%
1.11%
0.31%
0.95%
0.98%
2.77%
2.41%
2.37%
1.08%
1.36%
1.42%
1.81%
1.57%
1.92%
1.88%
1.83%
1.82%
1.21%
1.18%
0.29%
1.17%
1.49%
1.94%
1.61%
1.21%
1.51%
1.37%
1.60%
1.33%
1.19%
1.74%
Appendix
Time
12/1/1993
1/1/1994
2/1/1994
3/1/1994
4/1/1994
5/1/1994
6/1/1994
7/1/1994
8/1/1994
9/1/1994
10/1/1994
11/1/1994
12/1/1994
1/1/1995
2/1/1995
3/1/1995
4/1/1995
5/1/1995
6/1/1995
7/1/1995
8/1/1995
9/1/1995
10/1/1995
11/1/1995
12/1/1995
1/1/1996
2/1/1996
3/1/1996
4/1/1996
5/1/1996
6/1/1996
7/1/1996
8/1/1996
9/1/1996
10/1/1996
11/1/1996
12/1/1996
1/1/1997
2/1/1997
3/1/1997
iii

deviation
3.00
3.00
3.25
3.50
3.75
4.25
4.25
4.25
4.75
4.75
4.75
5.50
5.50
5.50
6.00
6.00
6.00
6.00
6.00
5.75
5.75
5.75
5.75
5.75
5.50
5.50
5.25
5.25
5.25
5.25
5.25
5.25
5.25
5.25
5.25
5.25
5.25
5.25
5.25
5.50
-1.10
-1.20
-1.20
-1.10
-1.00
-0.70
-0.70
-0.70
-0.60
-0.50
-0.40
-0.20
-0.10
-0.20
0.00
0.00
-0.40
-0.20
-0.20
-0.30
-0.30
-0.20
-0.10
-0.20
-0.20
-0.20
-0.10
-0.10
-0.20
-0.20
0.10
-0.10
0.30
0.20
0.20
0.00
0.00
0.10
0.20
0.20
-3.30
-3.60
-3.60
-3.30
-3.00
-2.10
-2.10
-2.10
-1.80
-1.50
-1.20
-0.60
-0.30
-0.60
0.00
0.00
-1.20
-0.60
-0.60
-0.90
-0.90
-0.60
-0.30
-0.60
-0.60
-0.60
-0.30
-0.30
-0.60
-0.60
0.30
-0.30
0.90
0.60
0.60
0.00
0.00
0.30
0.60
0.60
Personal
U.S. IndusInflation
consumption
expenditures
tion Growth
Growth
1.20
0.90
0.80
0.90
0.80
0.80
0.90
0.90
0.90
1.00
0.90
0.80
0.60
0.90
1.00
1.00
1.10
1.10
1.00
1.00
0.90
0.90
1.00
1.00
1.00
1.00
0.90
0.80
0.70
0.70
0.70
0.70
0.60
0.70
0.60
0.60
0.60
0.50
0.50
0.50
5.20
4.90
4.80
4.90
4.80
4.80
4.90
4.90
4.90
5.00
4.90
4.80
4.60
4.90
5.00
5.00
5.10
5.10
5.00
5.00
4.90
4.90
5.00
5.00
5.00
5.00
4.90
4.80
4.70
4.70
4.70
4.70
4.60
4.70
4.60
4.60
4.60
4.50
4.50
4.50
0.38
0.15
0.09
0.97
0.57
0.51
0.22
0.31
0.54
0.26
0.75
0.59
0.87
0.23
-0.08
0.19
-0.10
0.03
0.32
-0.45
0.92
0.69
-0.10
0.06
0.35
-0.66
1.33
-0.18
0.80
0.53
0.87
0.28
0.49
0.56
-0.05
0.67
0.74
0.05
1.22
1.03
1.61%
1.78%
0.71%
1.34%
1.18%
2.16%
1.53%
1.93%
1.22%
1.26%
0.70%
0.44%
0.83%
0.74%
1.64%
1.84%
1.62%
1.47%
0.87%
0.88%
1.00%
1.53%
1.45%
1.55%
1.51%
2.44%
1.81%
1.14%
0.87%
1.01%
1.29%
1.47%
1.48%
1.59%
1.60%
1.57%
1.41%
0.86%
0.45%
0.72%
Appendix
Time
4/1/1997
5/1/1997
6/1/1997
7/1/1997
8/1/1997
9/1/1997
10/1/1997
11/1/1997
12/1/1997
1/1/1998
2/1/1998
3/1/1998
4/1/1998
5/1/1998
6/1/1998
7/1/1998
8/1/1998
9/1/1998
10/1/1998
11/1/1998
12/1/1998
1/1/1999
2/1/1999
3/1/1999
4/1/1999
5/1/1999
6/1/1999
7/1/1999
8/1/1999
9/1/1999
10/1/1999
11/1/1999
12/1/1999
1/1/2000
2/1/2000
3/1/2000
4/1/2000
5/1/2000
6/1/2000
7/1/2000
iv

deviation
5.50
5.50
5.50
5.50
5.50
5.50
5.50
5.50
5.50
5.50
5.50
5.50
5.50
5.50
5.50
5.50
5.50
5.25
5.00
4.75
4.75
4.75
4.75
4.75
4.75
4.75
4.75
4.75
5.00
5.25
5.50
5.50
5.50
5.50
5.75
6.00
6.50
6.50
6.50
6.50
0.30
0.50
0.40
0.50
0.60
0.50
0.70
0.80
0.70
0.80
0.80
0.70
1.10
1.00
0.90
0.90
0.90
0.80
0.90
0.60
0.60
0.70
0.60
0.80
0.70
0.80
0.70
0.70
0.80
0.80
0.90
0.90
1.00
1.00
0.90
1.00
1.20
1.00
1.00
1.00
0.90
1.50
1.20
1.50
1.80
1.50
2.10
2.40
2.10
2.40
2.40
2.10
3.30
3.00
2.70
2.70
2.70
2.40
2.70
1.80
1.80
2.10
1.80
2.40
2.10
2.40
2.10
2.10
2.40
2.40
2.70
2.70
3.00
3.00
2.70
3.00
3.60
3.00
3.00
3.00
Personal
U.S. IndusInflation
consumption
expenditures
tion Growth
Growth
0.70
0.50
0.40
0.40
0.30
0.20
0.30
0.20
0.20
0.20
0.30
0.10
0.10
0.20
0.20
0.20
0.50
0.50
0.30
0.30
0.40
0.40
0.10
0.10
0.20
0.00
0.10
0.10
-0.10
0.00
0.10
0.10
-0.10
0.00
0.20
0.40
0.30
0.40
0.50
0.50
4.70
4.50
4.40
4.40
4.30
4.20
4.30
4.20
4.20
4.20
4.30
4.10
4.10
4.20
4.20
4.20
4.50
4.50
4.30
4.30
4.40
4.40
4.10
4.10
4.20
4.00
4.10
4.10
3.90
4.00
4.10
4.10
3.90
4.00
4.20
4.40
4.30
4.40
4.50
4.50
-0.21
0.76
0.60
0.34
1.53
0.79
0.55
1.02
0.44
0.78
-0.01
-0.12
0.55
0.58
-0.69
-0.48
2.35
-0.33
0.85
0.16
0.51
0.35
0.69
-0.07
0.34
0.90
-0.35
0.46
0.77
-0.34
1.59
0.72
0.75
0.13
0.35
0.69
0.63
-0.13
0.22
-0.02
1.65%
2.34%
1.97%
1.59%
1.32%
1.62%
0.95%
1.13%
1.04%
1.74%
2.01%
2.13%
1.78%
1.54%
1.68%
1.99%
1.68%
1.87%
1.30%
1.48%
1.13%
2.16%
2.20%
2.10%
1.50%
1.69%
2.01%
1.82%
1.67%
2.41%
2.09%
2.85%
2.33%
2.08%
1.29%
0.80%
1.37%
1.32%
2.01%
1.80%
Appendix
Time
8/1/2000
9/1/2000
10/1/2000
11/1/2000
12/1/2000
1/1/2001
2/1/2001
3/1/2001
4/1/2001
5/1/2001
6/1/2001
7/1/2001
8/1/2001
9/1/2001
10/1/2001
11/1/2001
12/1/2001
1/1/2002
2/1/2002
3/1/2002
4/1/2002
5/1/2002
6/1/2002
7/1/2002
8/1/2002
9/1/2002
10/1/2002
11/1/2002
12/1/2002
1/1/2003
2/1/2003
3/1/2003
4/1/2003
5/1/2003
6/1/2003
7/1/2003
8/1/2003
9/1/2003
10/1/2003
11/1/2003

deviation
6.50
6.50
6.50
6.50
6.50
6.00
5.50
5.00
4.50
4.00
3.75
3.75
3.50
3.00
2.50
2.00
1.75
1.75
1.75
1.75
1.75
1.75
1.75
1.75
1.75
1.75
1.75
1.25
1.25
1.25
1.25
1.25
1.25
1.25
1.00
1.00
1.00
1.00
1.00
1.00
0.90
1.10
1.10
1.10
1.10
0.80
0.80
0.70
0.60
0.70
0.50
0.40
0.10
0.00
-0.30
-0.50
-0.70
-0.70
-0.70
-0.70
-0.90
-0.80
-0.80
-0.80
-0.70
-0.70
-0.70
-0.90
-1.00
-0.80
-0.90
-0.90
-1.00
-1.10
-1.30
-1.20
-1.10
-1.10
-1.00
-0.80
2.70
3.30
3.30
3.30
3.30
2.40
2.40
2.10
1.80
2.10
1.50
1.20
0.30
0.00
-0.90
-1.50
-2.10
-2.10
-2.10
-2.10
-2.70
-2.40
-2.40
-2.40
-2.10
-2.10
-2.10
-2.70
-3.00
-2.40
-2.70
-2.70
-3.00
-3.30
-3.90
-3.60
-3.30
-3.30
-3.00
-2.40
Personal
U.S. IndusInflation
consumption
expenditures
tion Growth
Growth
0.60
0.60
0.50
0.60
0.60
0.60
0.70
0.70
0.60
0.50
0.70
0.70
0.70
0.60
0.60
0.80
0.70
0.60
0.60
0.40
0.50
0.50
0.30
0.20
0.40
0.20
0.20
0.00
-0.10
-0.10
-0.30
-0.30
-0.50
-0.40
-0.50
-0.50
-0.70
-0.80
-0.70
-0.90
4.60
4.60
4.50
4.60
4.60
4.60
4.70
4.70
4.60
4.50
4.70
4.70
4.70
4.60
4.60
4.80
4.70
4.60
4.60
4.40
4.50
4.50
4.30
4.20
4.40
4.20
4.20
4.00
3.90
3.90
3.70
3.70
3.50
3.60
3.50
3.50
3.30
3.20
3.30
3.10
-0.55
0.47
-0.40
-0.34
-0.72
-0.66
-0.60
-0.34
-0.25
-0.80
-0.69
-0.34
-0.71
-0.26
-0.71
-0.24
0.21
0.43
0.01
0.73
-0.02
0.65
1.06
-0.43
0.28
0.09
-0.49
0.44
-0.53
0.63
0.15
0.28
-0.96
0.08
0.51
0.10
-0.23
0.78
0.06
1.09
1.54%
0.99%
1.33%
1.37%
0.61%
0.46%
0.91%
1.21%
1.08%
0.91%
-0.61%
1.99%
0.89%
1.99%
-0.32%
0.78%
1.27%
1.76%
0.87%
1.25%
1.10%
1.72%
0.74%
0.44%
0.49%
1.55%
1.51%
1.15%
1.06%
0.91%
1.04%
1.06%
1.54%
2.63%
1.99%
1.25%
0.75%
1.06%
1.94%
1.58%
Appendix
Time
12/1/2003
1/1/2004
2/1/2004
3/1/2004
4/1/2004
5/1/2004
6/1/2004
7/1/2004
8/1/2004
9/1/2004
10/1/2004
11/1/2004
12/1/2004
1/1/2005
2/1/2005
3/1/2005
4/1/2005
5/1/2005
6/1/2005
7/1/2005
8/1/2005
9/1/2005
10/1/2005
11/1/2005
12/1/2005
1/1/2006
2/1/2006
3/1/2006
4/1/2006
5/1/2006
6/1/2006
7/1/2006
8/1/2006
9/1/2006
10/1/2006
11/1/2006
12/1/2006
1/1/2007
2/1/2007
3/1/2007
vi

deviation
1.00
1.00
1.00
1.00
1.00
1.00
1.25
1.25
1.50
1.75
1.75
2.00
2.25
2.25
2.50
2.75
2.75
3.00
3.25
3.25
3.50
3.75
3.75
4.00
4.25
4.50
4.50
4.75
4.75
5.00
5.25
5.25
5.25
5.25
5.25
5.25
5.25
5.25
5.25
5.25
-0.70
-0.70
-0.60
-0.80
-0.60
-0.60
-0.60
-0.50
-0.40
-0.40
-0.50
-0.40
-0.40
-0.30
-0.40
-0.20
-0.20
-0.10
0.00
0.00
0.10
0.00
0.00
0.00
0.10
0.30
0.20
0.30
0.30
0.40
0.40
0.30
0.30
0.50
0.60
0.50
0.60
0.40
0.50
0.60
-2.10
-2.10
-1.80
-2.40
-1.80
-1.80
-1.80
-1.50
-1.20
-1.20
-1.50
-1.20
-1.20
-0.90
-1.20
-0.60
-0.60
-0.30
0.00
0.00
0.30
0.00
0.00
0.00
0.30
0.90
0.60
0.90
0.90
1.20
1.20
0.90
0.90
1.50
1.80
1.50
1.80
1.20
1.50
1.80
Personal
U.S. IndusInflation
consumption
expenditures
tion Growth
Growth
-0.90
-0.90
-0.80
-0.40
-0.20
-0.30
-0.10
-0.20
-0.30
0.00
0.00
0.20
0.20
0.30
0.40
0.30
0.20
0.20
0.00
0.10
0.10
0.00
0.10
0.10
0.20
0.10
0.10
0.10
0.30
0.40
0.60
0.70
0.80
0.90
0.70
0.60
0.60
0.70
0.70
0.50
3.10
3.10
3.20
3.60
3.80
3.70
3.90
3.80
3.70
4.00
4.00
4.20
4.20
4.30
4.40
4.30
4.20
4.20
4.00
4.10
4.10
4.00
4.10
4.10
4.20
4.10
4.10
4.10
4.30
4.40
4.60
4.70
4.80
4.90
4.70
4.60
4.60
4.70
4.70
4.50
-0.23
0.05
0.69
-0.27
0.49
0.74
-0.83
0.85
0.67
-0.21
1.04
-0.02
0.69
0.73
0.87
-0.46
0.12
0.52
0.16
-0.03
0.33
-1.05
1.68
0.93
0.08
0.80
-0.33
-0.15
0.57
-0.33
0.38
0.07
0.38
-0.23
-0.55
-0.17
1.33
-0.71
0.29
0.49
1.85%
1.07%
1.76%
1.02%
1.62%
0.85%
1.96%
1.85%
2.14%
1.92%
1.34%
1.47%
1.25%
2.21%
1.07%
1.52%
1.53%
2.15%
1.87%
1.24%
1.23%
0.95%
1.39%
1.60%
1.61%
1.33%
1.33%
1.22%
1.47%
1.31%
1.27%
0.73%
0.76%
1.46%
1.83%
2.04%
1.64%
1.28%
1.19%
0.76%
Appendix
Time
4/1/2007
5/1/2007
6/1/2007
7/1/2007
8/1/2007
9/1/2007
10/1/2007
11/1/2007
12/1/2007
1/1/2008
2/1/2008
3/1/2008
4/1/2008
5/1/2008
6/1/2008
7/1/2008
8/1/2008
9/1/2008
10/1/2008
11/1/2008
12/1/2008
1/1/2009
2/1/2009
3/1/2009
4/1/2009
5/1/2009
6/1/2009
7/1/2009
8/1/2009
9/1/2009
10/1/2009
11/1/2009
12/1/2009
vii

deviation
5.25
5.25
5.25
5.25
5.25
4.75
4.50
4.50
4.25
3.50
3.00
2.25
2.00
2.00
2.00
2.00
2.00
2.00
1.50
1.00
0.16
0.15
0.22
0.18
0.15
0.18
0.21
0.16
0.16
0.15
0.12
0.12
0.12
0.50
0.60
0.40
0.40
0.40
0.30
0.30
0.30
0.00
0.00
0.20
-0.10
0.00
-0.40
-0.50
-0.80
-1.10
-1.20
-1.60
-1.90
-2.40
-2.70
-3.20
-3.60
-3.90
-4.40
-4.50
-4.40
-4.70
-4.80
-5.10
-5.00
-5.00
1.50
1.80
1.20
1.20
1.20
0.90
0.90
0.90
0.00
0.00
0.60
-0.30
0.00
-1.20
-1.50
-2.40
-3.30
-3.60
-4.80
-5.70
-7.20
-8.10
-9.60
-10.80
-11.70
-13.20
-13.50
-13.20
-14.10
-14.40
-15.30
-15.00
-15.00
Personal
U.S. IndusInflation
consumption
expenditures
tion Growth
Growth
0.30
0.20
0.20
0.20
0.10
0.10
0.20
0.30
0.40
0.50
0.30
0.40
0.30
0.30
0.40
0.50
0.50
0.50
0.20
0.00
-0.20
-0.30
-0.20
-0.20
-0.10
-0.20
-0.30
-0.50
-0.60
-0.50
-0.30
-0.30
-0.20
4.30
4.20
4.20
4.20
4.10
4.10
4.20
4.30
4.40
4.50
4.30
4.40
4.30
4.30
4.40
4.50
4.50
4.50
4.20
4.00
3.80
3.70
3.80
3.80
3.90
3.80
3.70
3.50
3.40
3.50
3.70
3.70
3.80
0.33
0.02
0.35
0.63
-0.50
0.44
-0.48
0.41
0.33
-0.29
-0.58
-0.10
-1.01
-0.21
-0.45
-0.28
-1.04
-4.05
0.34
-2.37
-3.06
-2.80
-0.11
-1.63
-0.38
-0.88
-0.34
1.47
1.16
0.63
-0.13
1.03
-0.14
0.82%
1.00%
1.34%
1.40%
1.78%
1.49%
1.26%
0.35%
0.66%
0.80%
1.05%
1.11%
0.70%
0.48%
-0.42%
-1.10%
-2.13%
-2.94%
-1.44%
-0.02%
0.83%
-0.05%
-0.32%
0.72%
1.01%
2.19%
0.82%
1.19%
0.44%
1.44%
Appendix
viii
Table 14: Data Set 2

Time
1/1/1988
2/1/1988
3/1/1988
4/1/1988
5/1/1988
6/1/1988
7/1/1988
8/1/1988
9/1/1988
10/1/1988
11/1/1988
12/1/1988
1/1/1989
2/1/1989
3/1/1989
4/1/1989
5/1/1989
6/1/1989
7/1/1989
8/1/1989
9/1/1989
10/1/1989
11/1/1989
12/1/1989
1/1/1990
2/1/1990
3/1/1990
4/1/1990
5/1/1990
6/1/1990
7/1/1990
8/1/1990
9/1/1990
10/1/1990
11/1/1990
12/1/1990
1/1/1991
2/1/1991
3/1/1991
4/1/1991
FF target rate Taylor Rule
6.81
6.63
6.50
6.75
6.75
7.25
7.50
7.69
8.13
8.13
8.13
8.38
9.00
9.00
9.75
9.75
9.75
9.81
9.56
9.06
9.06
9.00
8.75
8.50
8.25
8.25
8.25
8.25
8.25
8.25
8.00
8.00
8.00
7.75
7.50
7.00
6.75
6.25
6.00
5.75
7.60
7.60
7.75
7.75
7.65
8.05
8.05
7.80
7.90
8.05
7.95
8.40
8.20
8.60
8.55
8.30
8.30
8.10
8.30
8.00
7.80
7.80
7.90
7.90
7.90
8.25
8.75
8.50
8.50
8.75
8.75
9.40
9.30
9.00
8.85
8.65
9.20
9.10
8.40
8.30
Taylor rule
0,6-0,4
Taylor ruleokun
8.28
8.28
8.54
8.50
9.08
8.96
8.68
8.50
8.30
8.80
8.68
8.00
7.92
7.90
7.90
8.05
8.35
8.05
8.65
8.65
8.20
8.50
8.65
8.65
9.10
8.80
9.40
9.55
9.10
9.10
8.80
9.10
8.80
8.50
8.50
8.50
8.50
8.50
8.95
9.55
9.10
9.10
9.55
9.25
9.70
9.40
9.10
8.65
8.35
8.80
8.50
7.60
7.60
Taylor rule
Okun
0,6-0,4
9.00
9.00
9.50
9.10
9.44
9.08
8.80
8.26
7.94
8.32
7.96
7.04
7.08
Appendix
Time
5/1/1991
6/1/1991
7/1/1991
8/1/1991
9/1/1991
10/1/1991
11/1/1991
12/1/1991
1/1/1992
2/1/1992
3/1/1992
4/1/1992
5/1/1992
6/1/1992
7/1/1992
8/1/1992
9/1/1992
10/1/1992
11/1/1992
12/1/1992
1/1/1993
2/1/1993
3/1/1993
4/1/1993
5/1/1993
6/1/1993
7/1/1993
8/1/1993
9/1/1993
10/1/1993
11/1/1993
12/1/1993
1/1/1994
2/1/1994
3/1/1994
4/1/1994
5/1/1994
6/1/1994
7/1/1994
8/1/1994
9/1/1994
ix
5.75
5.75
5.75
5.50
5.25
5.00
4.75
4.50
4.00
4.00
4.00
3.75
3.75
3.75
3.25
3.25
3.00
3.00
3.00
3.00
3.00
3.00
3.00
3.00
3.00
3.00
3.00
3.00
3.00
3.00
3.00
3.00
3.00
3.25
3.50
3.75
4.25
4.25
4.25
4.75
4.75
8.20
8.05
7.80
7.45
7.30
7.10
7.25
6.95
5.90
5.70
5.85
5.85
5.60
5.50
5.40
5.15
4.85
5.30
5.10
4.95
5.30
5.55
5.30
5.40
5.25
5.15
5.05
5.25
5.15
4.80
5.05
5.25
4.75
4.60
4.80
4.70
4.85
5.00
5.00
5.05
5.25
Taylor rule
0,6-0,4
Taylor ruleokun
7.80
7.66
7.44
7.10
6.96
6.76
6.90
6.58
5.52
5.32
5.46
5.46
5.20
5.08
5.00
7.30
7.15
7.00
6.55
6.40
6.10
6.25
5.65
4.00
3.70
3.85
3.85
3.40
3.10
3.10
2.95
2.65
3.40
3.10
2.95
3.40
3.85
3.70
3.70
3.55
3.55
3.55
3.85
3.85
3.40
3.85
4.15
3.55
3.40
3.70
3.70
4.15
4.30
4.30
4.45
4.75
Taylor rule
Okun
0,6-0,4
6.72
6.58
6.48
6.02
5.88
5.56
5.70
5.02
3.24
2.92
3.06
3.06
2.56
2.20
2.24
Appendix
Time
10/1/1994
11/1/1994
12/1/1994
1/1/1995
2/1/1995
3/1/1995
4/1/1995
5/1/1995
6/1/1995
7/1/1995
8/1/1995
9/1/1995
10/1/1995
11/1/1995
12/1/1995
1/1/1996
2/1/1996
3/1/1996
4/1/1996
5/1/1996
6/1/1996
7/1/1996
8/1/1996
9/1/1996
10/1/1996
11/1/1996
12/1/1996
1/1/1997
2/1/1997
3/1/1997
4/1/1997
5/1/1997
6/1/1997
7/1/1997
8/1/1997
9/1/1997
10/1/1997
11/1/1997
12/1/1997
1/1/1998
2/1/1998
4.75
5.50
5.50
5.50
6.00
6.00
6.00
6.00
6.00
5.75
5.75
5.75
5.75
5.75
5.50
5.50
5.25
5.25
5.25
5.25
5.25
5.25
5.25
5.25
5.25
5.25
5.25
5.25
5.25
5.50
5.50
5.50
5.50
5.50
5.50
5.50
5.50
5.50
5.50
5.50
5.50
5.15
5.10
4.85
5.25
5.50
5.50
5.45
5.55
5.40
5.35
5.20
5.25
5.45
5.40
5.40
5.40
5.30
5.15
4.95
4.95
5.10
5.00
5.05
5.15
5.00
4.90
4.90
4.80
4.85
4.85
5.20
5.00
4.80
4.85
4.75
4.55
4.80
4.70
4.65
4.70
4.85
Taylor rule
0,6-0,4
Taylor ruleokun
4.75
4.90
4.75
5.05
5.50
5.50
5.05
5.35
5.20
5.05
4.90
5.05
5.35
5.20
5.20
5.20
5.20
5.05
4.75
4.75
5.20
4.90
5.35
5.35
5.20
4.90
4.90
4.90
5.05
5.05
5.50
5.50
5.20
5.35
5.35
5.05
5.50
5.50
5.35
5.50
5.65
Taylor rule
Okun
0,6-0,4
Appendix
Time
3/1/1998
4/1/1998
5/1/1998
6/1/1998
7/1/1998
8/1/1998
9/1/1998
10/1/1998
11/1/1998
12/1/1998
1/1/1999
2/1/1999
3/1/1999
4/1/1999
5/1/1999
6/1/1999
7/1/1999
8/1/1999
9/1/1999
10/1/1999
11/1/1999
12/1/1999
1/1/2000
2/1/2000
3/1/2000
4/1/2000
5/1/2000
6/1/2000
7/1/2000
8/1/2000
9/1/2000
10/1/2000
11/1/2000
12/1/2000
1/1/2001
2/1/2001
3/1/2001
4/1/2001
5/1/2001
6/1/2001
7/1/2001
xi
5.50
5.50
5.50
5.50
5.50
5.50
5.25
5.00
4.75
4.75
4.75
4.75
4.75
4.75
4.75
4.75
4.75
5.00
5.25
5.50
5.50
5.50
5.50
5.75
6.00
6.50
6.50
6.50
6.50
6.50
6.50
6.50
6.50
6.50
6.00
5.50
5.00
4.50
4.00
3.75
3.75
4.50
4.70
4.80
4.75
4.75
5.20
5.15
4.90
4.75
4.90
4.95
4.45
4.55
4.65
4.40
4.50
4.50
4.25
4.40
4.60
4.60
4.35
4.50
4.75
5.10
5.05
5.10
5.25
5.25
5.35
5.45
5.30
5.45
5.45
5.30
5.45
5.40
5.20
5.10
5.30
5.25
Taylor rule
0,6-0,4
Taylor ruleokun
5.38
5.50
5.36
5.50
5.50
5.32
5.46
5.40
5.20
5.12
5.28
5.22
5.20
5.80
5.80
5.65
5.65
6.10
5.95
5.80
5.35
5.50
5.65
5.05
5.35
5.35
5.20
5.20
5.20
5.05
5.20
5.50
5.50
5.35
5.50
5.65
6.10
6.25
6.10
6.25
6.25
6.25
6.55
6.40
6.55
6.55
6.10
6.25
6.10
5.80
5.80
5.80
5.65
Taylor rule
Okun
0,6-0,4
6.46
6.82
6.68
6.82
6.82
6.28
6.42
6.24
5.92
5.96
5.88
5.70
Appendix
Time
8/1/2001
9/1/2001
10/1/2001
11/1/2001
12/1/2001
1/1/2002
2/1/2002
3/1/2002
4/1/2002
5/1/2002
6/1/2002
7/1/2002
8/1/2002
9/1/2002
10/1/2002
11/1/2002
12/1/2002
1/1/2003
2/1/2003
3/1/2003
4/1/2003
5/1/2003
6/1/2003
7/1/2003
8/1/2003
9/1/2003
10/1/2003
11/1/2003
12/1/2003
1/1/2004
2/1/2004
3/1/2004
4/1/2004
5/1/2004
6/1/2004
7/1/2004
8/1/2004
9/1/2004
10/1/2004
11/1/2004
12/1/2004
xii
3.50
3.00
2.50
2.00
1.75
1.75
1.75
1.75
1.75
1.75
1.75
1.75
1.75
1.75
1.75
1.25
1.25
1.25
1.25
1.25
1.25
1.25
1.00
1.00
1.00
1.00
1.00
1.00
1.00
1.00
1.00
1.00
1.00
1.00
1.25
1.25
1.50
1.75
1.75
2.00
2.25
5.10
4.90
4.75
4.95
4.70
4.55
4.55
4.25
4.30
4.35
4.05
3.90
4.25
3.95
3.95
3.55
3.35
3.45
3.10
3.10
2.75
2.85
2.60
2.65
2.40
2.25
2.45
2.25
2.30
2.30
2.50
3.00
3.40
3.25
3.55
3.45
3.35
3.80
3.75
4.10
4.10
Taylor rule
0,6-0,4
Taylor ruleokun
5.04
4.84
4.66
4.82
4.56
4.42
4.42
4.14
4.16
4.22
3.94
3.80
5.20
4.90
4.45
4.45
4.00
3.85
3.85
3.55
3.40
3.55
3.25
3.10
3.55
3.25
3.25
2.65
2.35
2.65
2.20
2.20
1.75
1.75
1.30
1.45
1.30
1.15
1.45
1.45
1.60
1.60
1.90
2.20
2.80
2.65
2.95
2.95
2.95
3.40
3.25
3.70
3.70
Taylor rule
Okun
0,6-0,4
5.16
4.84
4.30
4.22
3.72
3.58
3.58
3.30
3.08
3.26
2.98
2.84
Appendix
Time
1/1/2005
2/1/2005
3/1/2005
4/1/2005
5/1/2005
6/1/2005
7/1/2005
8/1/2005
9/1/2005
10/1/2005
11/1/2005
12/1/2005
1/1/2006
2/1/2006
3/1/2006
4/1/2006
5/1/2006
6/1/2006
7/1/2006
8/1/2006
9/1/2006
10/1/2006
11/1/2006
12/1/2006
1/1/2007
2/1/2007
3/1/2007
4/1/2007
5/1/2007
6/1/2007
7/1/2007
8/1/2007
9/1/2007
10/1/2007
11/1/2007
12/1/2007
1/1/2008
2/1/2008
3/1/2008
4/1/2008
5/1/2008
xiii
2.25
2.50
2.75
2.75
3.00
3.25
3.25
3.50
3.75
3.75
4.00
4.25
4.50
4.50
4.75
4.75
5.00
5.25
5.25
5.25
5.25
5.25
5.25
5.25
5.25
5.25
5.25
5.25
5.25
5.25
5.25
5.25
4.75
4.50
4.50
4.25
3.50
3.00
2.25
2.00
2.00
4.30
4.40
4.35
4.20
4.25
4.00
4.15
4.20
4.00
4.15
4.15
4.35
4.30
4.25
4.30
4.60
4.80
5.10
5.20
5.35
5.60
5.35
5.15
5.20
5.25
5.30
5.05
4.70
4.60
4.50
4.50
4.35
4.30
4.45
4.60
4.60
4.75
4.55
4.55
4.45
4.25
Taylor rule
0,6-0,4
Taylor ruleokun
4.42
4.18
4.00
4.00
4.15
4.00
4.15
4.00
4.15
4.30
4.00
4.15
4.15
4.45
4.60
4.45
4.60
4.90
5.20
5.50
5.50
5.65
6.10
5.95
5.65
5.80
5.65
5.80
5.65
5.20
5.20
4.90
4.90
4.75
4.60
4.75
4.90
4.60
4.75
4.75
4.45
4.45
3.85
Taylor rule
Okun
0,6-0,4
4.42
3.70
Appendix
Time
6/1/2008
7/1/2008
8/1/2008
9/1/2008
10/1/2008
11/1/2008
12/1/2008
1/1/2009
2/1/2009
3/1/2009
4/1/2009
5/1/2009
6/1/2009
7/1/2009
8/1/2009
9/1/2009
10/1/2009
11/1/2009
12/1/2009
xiv
2.00
2.00
2.00
2.00
1.50
1.00
0.16
0.15
0.22
0.18
0.15
0.18
0.21
0.16
0.16
0.15
0.12
0.12
0.12
4.35
4.35
4.20
4.15
3.50
3.05
2.50
2.20
2.10
1.90
1.90
1.50
1.30
1.05
0.75
0.85
1.00
1.05
1.20
Taylor rule
0,6-0,4
Taylor ruleokun
4.26
4.22
4.04
3.98
3.32
2.86
2.28
1.96
1.80
1.56
1.52
1.08
0.88
0.66
0.34
0.42
0.52
0.58
0.72
3.85
3.55
3.10
2.95
1.90
1.15
0.10
-0.50
-1.10
-1.70
-2.00
-2.90
-3.20
-3.35
-3.95
-3.95
-4.10
-3.95
-3.80
Taylor rule
Okun
0,6-0,4
3.66
3.26
2.72
2.54
1.40
0.58
-0.60
-1.28
-2.04
-2.76
-3.16
-4.20
-4.52
-4.62
-5.30
-5.34
-5.60
-5.42
-5.28
Appendix
xv
Appendix B
90s Crisis:
Table 15: Paired Samples Statistics
Mean
Std. Deviation
Std. Error Mean
FF target rate
5,8750
28
1,65901
,31352
F2
6,539286
28
2,5301280
,4781492
FF target rate
5,8750
28
1,65901
,31352
F2(0,6-0,4)
5,962857
28
2,8435175
,5373743
Pair 1
Pair 2
Table 16: Paired Samples Correlations

FF target rate
Pair 1
& F2
FF target rate
Pair 2
& F2(0,6-0,4)
Correlation
Sig.
28
,663
,000
28
,637
,000
Table 17: Paired Samples Test

Paired Differences
95% Confidence Interval of the
Std. Devia-
Std. Error
tion
Mean
Sig. (2t
df
Difference
Mean
tailed)
Lower
Upper
FF target rate
Pair 1
-,6642857 1,8947226
,3580689
-1,3989824
,0704110
-1,855
27
,075
-,0878571 2,1978396
,4153526
-,9400904
,7643761
-,212
27
,834
& F2
FF target rate
Pair 2
& F2(0,6-0,4)
Appendix
Figure 6: FF vs. F2 vs. F2 (06-04)
xvi
Appendix
xvii
Dotcom Crisis

Mean
Std. Deviation
Std. Error Mean
FF target rate
3,7500
24
1,92664
,39327
F2
5,0563
24
1,22858
,25078
FF target rate
3,7500
24
1,92664
,39327
F2(0,6-0,4)
5,0358
24
1,44848
,29567
Pair 1
Pair 2

FF target rate
Pair 1
& F2
FF target rate
Pair 2
& F2(0,6-0,4)
Correlation
Sig.
24
,946
,000
24
,952
,000

Paired Differences
95% Confidence Interval
Mean
Pair
FF target rate
& F2
1,30625
Pair
FF target rate
& F2(0,6-0,4) 1,28583
Std. De- Std. Error

viation
of the Difference
df
Sig. (2tailed)
Mean
Lower
Upper
,86267
,17609
-1,67052
-,94198
,70282
,14346
-1,58261
-,98906
7,418
8,963
23
,000
23
,000
Appendix
xviii
Appendix
xix
Global Financial Crisis

Mean
Std. Deviation
Std. Error Mean
FF target rate
,7290
20
,82609
,18472
F2
-,7025
20
3,00799
,67261
FF target rate
,7290
20
,82609
,18472
F2(0,6-0,4)
-1,6130
20
3,48095
,77836
Pair 1
Pair 2

FF target rate
Pair 1
& F2
FF target rate
Pair 2
& F2(0,6-0,4)
Correlation
Sig.
20
,923
,000
20
,919
,000

Paired Differences
95% Confidence Interval
Mean
Pair
FF target rate
& F2
Pair
FF target rate
& F2(0,6-0,4)
Std. De- Std. Error

viation
of the Difference
df
Sig. (2tailed)
Mean
Lower
Upper
1,43150 2,26832
,50721
,36989
2,49311
2,822
19
,011
2,34200 2,74137
,61299
1,05900
3,62500
3,821
19
,001
Appendix
xx

Monetary Policy and The Global Financial Crisis: Case of The United States of America

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JNKPING INTERNATIONAL BUSINESS SCHOOL

Masters thesis within Financial Economics

Daniel Wiberg Ph.D.

Master Thesis in Financial Economics

Monetary Policy and the Global Financial Crisis: Case of

Monetary Policy, Federal Fund Rate, Global Financial Crisis

Monetary Policy in the U.S.: .................................................................................. 5

The financial Crisis ............................................................................................... 22

Empirical Analysis ................................................................................................ 35

Methodology and Data .................................................................................. 35

rt: Real interest rate

(yt -yt*): output gap

yt: real GDP

yt*: Trend GDP,

(t -*): inflation gap

Clarida R, Gal J, Gertler M (2000)

Problem Discussion and Research Questions

John B. Taylor, Monetary policy rules, National bureau of economic research

Monetary Policy in the U.S.

2 Monetary Policy in the U.S.

Monetary Policy in the U.S.

2.1 The Theory of Monetary Policy

Refers to the Central Bank which is an independent Government entity

Monetary Policy in the U.S.

2.1.2 Monetary policy under the Glorious Thirties

2.1.3 Monetarist Policies

When output grew at a rate greater than its natural rate.

Monetary Policy in the U.S.

It is possible to reduce inflation by gradually reducing money supply.

2.2 Role of Monetary Policy

Monetary Policy in the U.S.

Monetary Policy in the U.S.

2.3 The Federal Reserve System and Monetary policy

Figure 1: The Federal Reserve System

Monetary Policy in the U.S.

Monetary Policy in the U.S.

Table 1: Reserve ratios for all depository institutions

Net transaction accounts:

For the amount from $0 to (and including) $10.7 million

For the amount over $10.7 minion to ( including) $55.2 million

For the amount over $55.2 million

Non personal time deposits

Source: Reserve Maintenance Manual, Federal Reserve System, October 2009

2.3.1 Legislative guidance:

United States Congress Joint Economic Committee (1985, p. 1).

Monetary Policy in the U.S.

The Federal Open Market Committee (FOMC)

Monetary Policy in the U.S.

Monetary Policy in the U.S.

Open Market Operations

Total par value

U.S. Treasury bills

U.S. Treasury notes and bonds, nominal

U.S. Treasury notes and bonds, inflation-indexed10

Federal agency debt securities11

Mortgage-backed securities12 (MBS)

Total SOMA securities holdings

Source: The Federal Reserve H.4.1.

Includes inflation compensation

Monetary Policy in the U.S.

The Greenspan Standards

Monetary Policy in the U.S.

Discretion rather than rules: