Financial crisis, Taylor rule and the Fed

Abstract

We investigate how the Federal Reserve (Fed) hit the zero lower bound (ZLB) interest rate while operating under a Taylor-type policy rule. We estimate a reaction function, and the results indicate that during the crisis Fed increased the weight on output without also increasing the weight on inflation which led them to hit the ZLB.0

Keywords:

• financial crisis
• Taylor rule
• zero bound

JEL Classification:

• E58

Notes

¹  Dummies are selected according to the test results of Carrion-i-Silvestre et al. (2009). Other dummies are ignored because they are statistically insignificant at the conventional levels. These dummies are constructed as follows: DUM73 = 1 from 1973Q1 to 1974Q4 and 0 otherwise, DUM80 = 1 from 1980Q1 to 1981Q4 and 0 otherwise and DUM91 = 1 from 1991Q1 to 1992Q4 and 0 otherwise.

²  For example, DUMFC in 1954Q3 to 2007Q1 sample is constructed as 1 in 2007Q1 and 0 otherwise. DUMFC in 1954Q3 to 2007Q2 sample is constructed as 1 in 2007Q1 and 2007Q2 and 0 otherwise. A similar process is used to construct DUMFC for samples beyond 2007Q2.

³  Estimates of the intercept and dummies are not reported for brevity.

⁴  The t-statistics or p-values are not reported for brevity.

⁵  We derive price volatility using the GDP deflator. GARCH model was used to attain the series.