Lagged interest rate and its change i

Lagged interest rate and its change (i, Δi) and the output gap (y) were added to the new function in order to capture past behavior or the autoregressive process of the interest rate. By using OLS – Ordinary Least Squares estimates the results obtained by the authors showed to be different from the Taylor model. For the Aminoallyl-dCTP - Cy3 Greenspan, the coefficient of the lagged output gap was not significant. However, as expected the lagged interest rate did show to be significant. The coefficient estimate of 0.42 led to the conclusion that the monetary policy conducted indeed obeyed a more gradual process. Thus, the monetary policy conducted was more smoothing than in previous periods. The results also reinforced that each administration had its own monetary policy conduct. In other words, there is no single rule for all administrations. Although the changes did not affect the Central Bank credibility since price stability was guaranteed; it, however, demanded from agents’ new learning on the execution of the monetary policy for each administration. Do the change cause any extra cost to society in terms of high interest rates? Unfortunately, their study does not answer this question. A broader research conducted by Clarida et al. (2000) focuses on evaluating the monetary policy before and after Paul Volker (the breaking period was 1979). They propose a reaction function that considers the deviation from expected inflation or the interest rate deviation from a target one. Though not formally assumed in their paper, this can be seen as a way of comparing the Central Bank\'s Credibility in the two periods. The reaction function specification follows a linear relationship:where is the nominal interest rate of period t; represents the percentage change of the price level between periods t and t+k; is the inflation target; X is a measurement of the proportion of the output gap from period t to t+q; E is the expectation operator; is the information set available to the individuals; and r* is the desired interest rate when the inflation and output do not deviates from their respective goals. The authors indicated that the interest rate behavior is measured by the sign and the size of the coefficients (β) and (γ). Nevertheless, Clarida et al. (2000, p. 153) point out limitations of such a reaction function. First, the specification assumes an instantaneous change in the interest rate. Second, it ignores any smoothing changes in the interest rate over time. Third, it reflects constant and systematic change in the Fed\'s conduct of monetary policy in response to actual economic conditions. Fourth, it assumes that the Fed has total control over the interest rate in keeping it around a desired level. To overcome these limitations the authors made additional assumptions by bringing the expected autoregressive process of the interest rate back into the equation. More precisely, They also use the generalized method of moments (GMM) to obtain estimates of the parameters . The method was applied to data that was divided into two periods. The first considers the years 1960:1 to 1979:2. This period includes the following Fed\'s Chairmans: William M. Martin, Arthur Burns and G. William Miller. The second period represented by the years of 1979:3 through 1996:4 corresponds to the administrations of Paul Volcker and Alan Greenspan. Their results can be summarized as follows: (i) the inflation and output gap expectation do play a role, especially when considered the forward looking process; (ii) the authors identified significant changes in the conduct of monetary policy between the periods of pre and post 1979; (iii) the estimate for the coefficient associated with expected inflation is significant in both periods, but below the unit in the period before Volcker, around 0.83, and greater than unity for the Volcker–Greenspan period, 2.15; (iv) the coefficient (γ) related to the output gap is significant in both periods, but negligible in the Volcker–Greenspan period; and (v) the coefficient (ρ) that captures the smoothing effect of the monetary policy being conducted showed to be significant; hence it confirms that the Fed did practice smoothing procedure in setting up the interest rate in both periods.