module 31 Monetary Policy and the Interest Rate 311
As you can see, the Fed has tended to raise interest rates when the output gap is rising—
that is, when the economy is developing an inflationary gap—and cut rates when the
output gap is falling. The big exception was the late 1990s, when the Fed left rates
steady for several years even as the economy developed a positive output gap (which
went along with a low unemployment rate).
One reason the Fed was willing to keep interest rates low in the late 1990s was that
inflation was low. Panel (b) of Figure 31.4 compares the inflation rate, measured as the
rate of change in consumer prices excluding food and energy, with the federal funds
rate. You can see how low inflation during the mid-1990s and early 2000s helped en-
courage loose monetary policy both in the late 1990s and in 2002–2003.
In 1993, Stanford economist John Taylor suggested that monetary policy should fol-
low a simple rule that takes into account concerns about both the business cycle and in-
flation. The Taylor rule for monetary policyis a rule for setting the federal funds rate
that takes into account both the inflation rate and the output gap. He also suggested
that actual monetary policy often looks as if the Federal Reserve was, in fact, more or
less following the proposed rule. The rule Taylor originally suggested was as follows:
Federal funds rate = 1 +(1.5 ×inflation rate) +(0.5×output gap)YearOutput
gapFederal
funds rate4%
2
0
–2
–4
–6
–812%
10
8
6
4
2
0
1985Federal
funds
rateYear1985YearInflation
rate6%
5 4 3 2 1 0–1
–212%
10
8
6
4
2
0
1990 1995 2000 2005 2009 1985 1990 1995 2000 2005 20091990 1995 2000 2005 2009Federal
funds
rate(a) Output Gap vs. Federal Funds Rate(c) The Taylor Rule(b) Inflation Rate vs. Federal Funds RateOutput gap
Federal funds rate
Federal funds rateInflation rateFederal funds rateFederal funds rate
(Taylor rule)12%
10
8
6
4
2
0
–2Tracking Monetary Policy Using the Output Gap, Inflation, and
the Taylor Rulefigure 31.4
Panel (a) shows that the federal funds rate usually rises when
the output gap is positive—that is, when actual real GDP is
above potential output—and falls when the output gap is
negative. Panel (b) illustrates that the federal funds rate tends
to be high when inflation is high and low when inflation is
low. Panel (c) shows the Taylor rule in action. The green line
shows the actual federal funds rate from 1985 to 2009. The
purple line shows the interest rate the Fed shouldhave set
according to the Taylor rule. The fit isn’t perfect—in fact, in
2009 the Taylor rule suggests a negative interest rate, an im-
possibility—but the Taylor rule does a better job of tracking
U.S. monetary policy than either the output gap or the infla-
tion rate alone.
Source: Federal Reserve Bank of St. Louis; Bureau of Economic Analysis;
Bureau of Labor Statistics.TheTaylor rule for monetary policyis a
rule for setting the federal funds rate that
takes into account both the inflation rate and
the output gap.