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The Taylor Rule: Did the Fed use Discretion Instead?
The theoretical literature on monetary policy favours the use of rules over discretion and most macroeconomic models include an interest rate rule. Since John Taylor‘s seminal paper published in 1993 the Taylor rule has been the preferred specification of the rule. It is based on evidence for the period 1987-1992 where it explains the Fed funds rate well. The issue addressed in this paper is whether the Fed ever actually followed the original Taylor rule and, in particular, the Taylor Principle of raising the real Fed funds rate to control inflation. And if, as we found, it neither followed the original rule nor adhered to the Taylor principle, what were the main factors that determined the administered Fed funds rate and why might the Fed have chosen to use its discretion rather than follow the original rule and the Taylor Principle? Using time-vary coefficient estimates of a number of versions of the Taylor rule, it is shown that in all of these versions the contribution of inflation in the determination of the Fed funds rate has steadily declined - especially after the financial crisis - thereby breaching the Taylor principle. It seems, therefore, that the Fed has used discretion rather than following the original Taylor rule. The main reason for this seems to be the Fed‘s dual mandate. Nonetheless, apart from 2021-2022 the Fed has maintained inflation close to its 2 per cent target. We also find that the concern over whether fiscal dominance would result in high interest rates undermining debt solvency is not born out by the evidence.
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