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• W259768583 abstract "This paper develops a formula for setting interest rates that are related to, or even reflect or indicate, real economic growth rates, as opposed to growth rates assumed by policy makers. The rates adjust for deviations of the projected GDP growth rate and inflation from the potential GDP growth rate and target inflation. The formula developed in this paper to make decisions on interest rates allows for the US Federal Fund rate to fully adjust for any gap between the projected and potential Gross National Product and also for the gap between projected and potential interest rates. Implications for policy makers of the formula for setting interest rates are discussed. Introduction The Federal Reserve is mandated to seek full employment and price stability through its monetary policy role. A policy instrument often used by the Fed is to target the federal funds rate. Although members of this institution vote on policy measures based on their own best judgment, it is recommend that they use some simple rules that may be applied consistently over time. A rule suggested by Taylor( 1993, 1998, 1999, 2007) is often said to be used by central bankers around the world for targeting short term interest rates. In this paper we propose an alternative rule which is more cognizant of the projected GDP growth rate and fully adjusts for any deviation from the target inflation and the potential GDP. Taylor suggested a formula for setting the real federal funds rate as a function of the difference between the real GDP and potential GDP and the difference between the actual and target inflation rates. Specifically, the rule was i = π + 2 + .5(?) + .5(π-2) (1) where i = the federal funds rate π = the rate of inflation over the past four quarters y = the percent deviation of real GDP from the potential GDP Now y = 100(Y-Y*)/Y* Y = real GDP, and Y* = real potential GDP The formula given in equation (1) is now known as the Taylor Rule and is purportedly used by many central bankers around the world for targeting short term interest rates. There is empirical evidence that the Fed's policy regarding the fed fund rates in the recent decade may indeed be described by the Rule. We are proposing a revised scheme where the federal funds rate fully adjusts to inflation, GDP growth and deviations from the potential GDP and target inflation. Specifically i = y* + π* + (y -y*) + (π- π*) (2) = y + π (2b) where, y = the projected real GDP growth rate π = projected inflation rate y* = potential GDP growth rate π* = the target inflation rate. Equation (2) indicates that that the nominal interest rate should vary equally with potential GDP growth rate, the target inflation, the difference between projected and potential GDP and the difference between projected and the target inflation rate . The reason the federal funds rate adjusts with the potential GDP growth rate is that it implies that capital should be rewarded at the same rate as the gain in the economy. Similarly, interest rates vary equally with the forecasted inflation rate in order to keep real interest rate constant. For each percentage point by which the projected real GDP falls below the potential GDP, the federal funds rate falls by an equal amount and the converse is true if the GDP exceeds the potential GDP Likewise, for each percentage point the actual inflation exceed the target rate, the fed funds rate rises by one percent and conversely. The argument for allowing the fed fund rate to fully adjust for the GDP gap and the difference between actual and target inflation is that it should prevent any buildup of the gaps so that prolonged or drastic action would not be needed in achieving the twin goals for GDP and inflation. …" @default.
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• W259768583 date "2011-09-01" @default.
• W259768583 modified "2023-09-23" @default.
• W259768583 title "Setting Interest Rates That Relate to Real Economic Growth: Development of a Formula" @default.
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