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Working Papers

August 2001, No. 01-5

The Taylor Principle, Interest Rate Smoothing and Fed Policy in the 1970s and 1980s

Yash P. Mehra

(For an updated version of this working paper, see WP 02-3)

Using a real time estimate of the output gap, this article estimates Taylor-type policy rules that predict the actual behavior of the funds rate during two sample periods, 1968Q1 to 1979Q2 and 1979Q3 to 1987Q4. The inflation rate response coefficient is close to unity over the first sub period and well above unity over the second, suggesting Fed policy violated the Taylor principle during the first period. The adjustment of the funds rate in response to fundamentals is not as rapid during the first period as it is during the second. Together these results support the conventional view that the Fed was "too timid" and "too sluggish" during the late 1960s and the 1970s. Though the Fed smoothes interest rates, the degree of smoothing exhibited is far less than what was previously estimated. The funds rate response to its fundamentals is complete within one year during the first period and within one quarter during the second.

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