INTEREST RATES, SHORT-RUN MONETARY POLICY, AND THE FEDERAL RESERVE REACTION FUNCTION

This dissertation is an examination of the monetary policy reaction function of the Federal Reserve. Four major topics are covered: (1) The theoretical foundations justifying the study and estimation of a policy reaction function; (2) Econometric estimates of a monthly reaction function of the Federal Open Market Committee; (3) Examination of evidence that financial markets utilize information provided by the reaction function; and (4) The incorporation of a reaction function into a medium-sized econometric model.;Econometric estimates of a reaction function for the Federal Open Market Committee are presented for the period 1974 to 1980. The Federal funds target is used as the dependent variable. Experiments with a PROBIT model are reported. The Federal Reserve was found to respond to inflation, unemployment, the exchange rate, and money supply growth.;The final two topics are applications of the results of estimating the Federal Reserve's reaction function. First, market forecasts of the Treasury bill rate are examined to determine if the market utilizes information in the same way the Federal Reserve responds to information in setting interest rates. Finally, the reaction function is incorporated into a medium-sized econometric model developed by Ray Fair. Simulations are run under various assumptions about shifts in the policy reaction function. It was found that relatively small shifts in the coefficients of the reaction function could result in large changes in forecast results. However, these shifts did not appear to significantly affect the size of the fiscal policy multiplier.;The theoretical model derives optimal monetary policy using optimal control techniques. A discussion of intermediate targets follows and a revised model is introduced which incorporates intermediate targets.