The Federal Funds Rate and the Monetary Transmission Mechanism

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9308301 Hamilton There is currently no consensus whatever among macroeconomists on the effect of monetary policy on the economy. Keynesian models suggest that faster monetary growth would lower the nominal interest rate by expanding the supply of credit, whereas classical models would predict that faster monetary growth could well raise the nominal interest rate as a result of inflationary expectations. The confusion and disagreements among academic economists notwithstanding, the people who work for the Federal Reserve's trading desk have the daily responsibility for using open market operations to keep the Federal funds rate trading within a narrow range. This project is designed to develop a convincing scientific measure of the effects that anticipated and unanticipated open market operations by the Federal Reserve have on nominal interest rates and real economy activity at horizons from one day to two years. This project has five components, each of which would comprise a separate and major research effort. The first step is to develop a statistical description of daily fluctuations in the Fed funds rate that is consistent with profit maximization by banks. The second step uses this description of the daily Fed funds market along with an analysis of banks' incentives for borrowing at the discount window to arrive at a prediction of the dynamic effects of open market operations on the Fed funds rate. The third step weeks independent verification of the predicted multipliers based on a biweekly vector autoregression (VAR); if the VAR proves to be inconsistent with the theoretical analysis, the framework will need to be modified accordingly. The fourth step uses term structure relations to predict the effects of open market operations on interest rates other than the Fed funds rate. Again it is possible to corroborate these predictions independently with vector autoregressions. The fifth step will use these results to assess the dynamic conseque nces of open market operations for unemployment, output, and inflation. ***