| A vast literature has emerged using Taylor rules to analyze the development of monetary policy over time in different countries. However, unrealistic assumptions regarding the availability of data pervade existing studies. In particular, the following problems stand out: (i) the use of contemporaneous rather than lagged data; (ii) the use of revised rather than unrevised data; (iii) the use of lead variables, unavailable at the time of original policy response, in estimating potential output; and (iv) the ignorance of extra information available to policy makers and reflected in various forecasts.; In order to evaluate these distortions, I have estimated Taylor rules using different sets of estimates for inflation and output gap over three sub-samples, corresponding to the chairmanships of Arthur Burns, Paul Volcker, and Alan Greenspan at the Federal Reserve Board of Governors.; First, I show that inclusion of lead variables when estimating the potential level of output has a large impact, producing coefficients that may have a value of less than half the true value. Using revised rather than raw data has smaller, although sizable, effect on the final results. Finally, using contemporaneous rather than lagged data appears to have a negligible effect.; Next, I produce empirical evidence suggesting that the Fed pursues a much less “mechanical” monetary policy than has often been assumed, one which takes into account expected future developments. Taken into account in my study are forecast series, calculated by the Fed's Research Department, which allow calculation of future inflation shocks as expected by the Fed. These are significant in the estimated Taylor rules, confirming that policymaking is forward-looking.; I also demonstrate possible flaws in Taylor rules, which assume a constancy of variables, such as NAIRU or the inflation target, and evaluate costs associated with the usage of incorrect estimates of output gap when formulating monetary policy responses.; Overall, my results suggest that the galloping inflation of the 70s was caused by poorly designed policy. I also demonstrate that US monetary policy during the chairmanship of Alan Greenspan and possibly that of Paul Volcker was much more anti-inflationary than is generally regarded. |
