Name _______________________ Last 4 (PSU ID ...



Name _______________________ Last 4 (PSU ID) ________ First 2 letters of last name _____

Homework Assignment #3 – Econ 351 –Fall 2017 –PLEASE STAPLE, DUE, MONDAY DECEMBER 4 AT THE BEGINNING OF CLASS: NO LATE HWS ACCEPTED.

1) (50 points) After 'getting' off the zero bound in December of 2015, the Fed is poised is currently in a tightening cycle. We have discussed various Taylor rule specifications. To answer this question, please use the data below: (please round all data to two decimal places)

Click Here for PCE overall (use most recent 12 month change)

Click Here for PCE core (minus food and energy) (use most recent 12 month change)

Click Here for the natural rate of unemployment (NAIRU) (use 2017 Q3)

Click Here for the actual rate of unemployment (use most recent)

Click Here for real GDP (use 2017 Q2)

Click Here for Real Potential GDP (use 2017 Q2)

Let's pretend that you are hired to brief the FOMC during their December 12 - 13, 2017 meeting and you are responsible for informing the policy makers as to where policy is currently relative to various Taylor rule specifications (recall the term guidepost). Assume it is the first day of the meeting (December 12). Click Here for the actual (effective) federal funds rate. Please show all work!!!

a) (10 points) Using the standard original Taylor Rule specification (with r* = 2), what is the federal funds rate implied by this rule and is the Fed currently hawkish or dovish relative to this rule. Explain.

b) (10 points) Using the Mankiw rule, what is the federal funds rate implied by this rule and is the Fed currently hawkish or dovish relative to this rule. Explain.

c) (10 points) Using the Chud Okun rule (with r* = 2), what is the federal funds rate implied by this rule and is the Fed currently hawkish or dovish relative to this rule. Explain

We discussed how most economists have argued that the natural real rate of interest is lower than Taylor assumed = 2%. As evidence of this, we can look at the most recent projection material from the FOMC. Consider the graphic below.

[pic]

d)(10 points) Calculate the longer run neutral nominal funds rate and along with it, the implied natural real rate of interest (assume the inflation target is 2%). Simply multiply each dot by its respected value and divide by 15 (the number of 'votes'). Please show work. Take the solution to two decimal places.

e)(10 points) Given your answer in part d), how would your answers change in parts a), b) and c) with regard to the degree of dovishness? Be specific and use numbers! Assume that Mankiw originally assumed a natural real rate just like Taylor?

2)(40 points total)

a)(10 points) The graphic below is from the Jan, 2012 meeting - calculate the neutral funds rate and the natural real rate of interest just like you did question #1 part e). Assume again, the inflation target is 2%.

[pic]

b)(10 points) Why are these numbers (the neutral funds rate and natural real rate) so different from the most recent numbers?

c) (10 points) Why are these numbers so important from a policy perspective? Imagine entering a recession now vs entering a recession back in 2012. Has the Fed lost bullets, if so, how many?

From a WSJ article titled Yellen Says Fed May Need to Use Unconventional Policy Again Some Day (10/20/17) Janet Yellen was quoted with the following:

The “probability that short-term interest rates may need to be reduced to their effective lower bound at some point is uncomfortably high, even in the absence of a major financial and economic crisis,” she said in remarks released ahead of delivery to the National Economists Club.

That is because the neutral rate of interest—the inflation-adjusted interest rate that is consistent with the economy expanding at its full potential without overheating—“is much lower than in previous decades,” she said.

Also from the WSJ in an article titled "Rethinking the Widely Held 2% Inflation Target," consider the following graphic:

[pic]

d) (10 points) Assuming that the current real natural rate is zero, like it is in graphic, what would be the neutral funds rate according to the original Taylor rule? Assume the inflation target is 2%. Use the actual data for PCE inflation an the GDP gap as you did in question #1 part a). Is the Fed less dovish or more dovish using this modified Taylor rule?

3)(40 points) The Republicans have been trying to pass legislation that would force the Fed to follow explicitly, a mathematical rule such as the Taylor Rule – consider this title and an excerpt from the WSJ:

House Republicans Want Fed to Adopt Policy-Making Rules

By

Pedro Nicolaci da Costa

Jul 9, 2014 6:30 am ET

Several House Republicans are embracing Stanford University economist John B. Taylor’s call for the Federal Reserve to adopt a mathematical rule for determining interest rates, stepping into a long-running debate among central bankers about how to set monetary policy.

The House Financial Services Committee will hold a hearing Thursday “Legislation to Reform the Federal Reserve on Its 100-year Anniversary,” at which Mr. Taylor and other Fed critics are scheduled to testify.

The hearing will focus on a bill—introduced Tuesday by Republican Reps. Scott Garrett of New Jersey and Bill Huizenga of Michigan–that would, among other things, policy require the Fed to provide Congress with “a clear rule to describe the course of monetary,” according to a committee announcement. Such a rule would be an equation showing how the Fed would adjust interest rates in response to changes in certain economic variables. One well-known example is the Taylor rule, named for Mr. Taylor.

And from the WJS 10/20/2017

How High Could Rates Go if John Taylor Becomes Fed Chairman?

Under the 1993 ‘Taylor rule,’ the Fed’s benchmark rate would be over a percentage point higher than where it is now

Speaking at a Boston Fed conference last week, Mr. Taylor repeated his argument in favor of basing Fed interest-rate policy on established rules, something that some Republican lawmakers have pushed for. He said he created his rule to provide “something relatively simple that would not create shocks and could react to shocks well.”

Fed officials see value in Mr. Taylor’s rules as a way to help them think about policy. But they also believe the value is limited. Officials such as New York Fed President William Dudley have long argued rules don’t take account of financial conditions, which are a critical driver of the economy’s performance.

Boston Fed President Eric Rosengren at the conference last week argued against requiring the Fed to follow a formal rule. Mr. Rosengren pointed to an example of when the Taylor rule would have led the central bank astray. “In 2007, the actual federal-funds rate decreased much sooner than would have been implied by the 1993 Taylor rule,” he said. “In the case of 2007, a much slower reaction to the impending financial problems would have exacerbated what was already a very serious economic downturn.”

a)(10 points) Let’s go back to 2007-2008 and revisit the criticism of the Taylor Rule during this time. Using the original Taylor Rule (part a) of Q #1) calculate what the federal funds rate would have been if the Fed followed the Taylor Rule vs what it actually was from the 4th quarter of 2007 to the 3rd quarter of 2008. You can use the Taylor Rule worksheet on our home page to save you some time. Are your results consistent with Mr. Rosengren’s argument?

b)(10 points) Let’s return to the New economy period. Consider only 1996. Using the Taylor Rule worksheet, calculate what the average of the funds rate would have been over the entire year of 1996 under the original Taylor Rule (4 values given quarterly data divided by 4) vs what the actual average was for the federal funds rate over the same period. What could explain this difference? If the difference was due entirely to the change in the natural real rate of interest, what was the natural real rate of interest during this time and why was it so different than Taylor’s original assumption?

c)(10 points) Let us return back to the 2007 – 2008 period. Bernanke has a similar criticism of the Taylor Rule during this period. Go to the speech below and go to pages 29 and 30 (graphs). As you can see, the Taylor Rule suggests the funds rate should have been rising at this time but instead it was falling. What are Bernanke’s thoughts on this scenario? What is the fix? In your answer, be sure to mention how Bernanke would modify the Taylor rule in the context of this period. Be sure to mention over all inflation vs the core rate of inflation. Also mention the merits of using forecasted inflation vs. actual inflation.

Bernanke’s Speech

It is well known that Janet Yellen is considered an inflation dove. In fact, you pretty much showed that the Yellen Fed is currently dovish. We also discussed how Greenspan was sometimes dovish and sometimes hawkish. Let's go back to the new economy years and the Greenspan legacy article.

In September 1996, Ms. Yellen and Laurence Meyer, a new Fed governor and a former top-ranked independent economic forecaster, made a rare visit to Mr. Greenspan's office. It was the week before an FOMC meeting and Ms. Yellen and Mr. Meyer hoped to influence his recommendation on interest rates.

The pair worried that unemployment had been so low for so long that a resurgence in inflation was inevitable. Conventional economic models held that companies would have to pay higher wages to attract enough staff and would pass on those costs to consumers as higher prices. They warned Mr. Greenspan that if he didn't recommend higher rates soon, they might vote against him, recalls Mr. Meyer, who has since joined an economic forecasting firm.

When the meeting rolled around the next week, it was a tense affair. A Reuters report had made public the fact that eight of the 12 regional banks had asked for higher rates.

Mr. Greenspan disagreed and told the committee he wanted to hold rates firm. An important reason, he argued, was that the government's productivity data were wrong.

d)(10 points) Using the Taylor Rule worksheet, was the Greenspan Fed hawkish or dovish according to the original Taylor Rule during the 3rd quarter of 1996? Given that Janet Yellen was trying to convince Greenspan to raise rates during this period, is this consistent with Janet Yellen's dovish reputation? Why or why not - use actual numbers.

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