Center for Economic Research, Department of Economics, University of Minnesota
Empirical studies show that the Federal Reserve System (Fed) has been smoothing
short-term nominal interest rates across seasonal cycles, but has allowed interest rates
to co-move with output over business cycles, despite striking similarities between the
two cycles in terms of output co-movements and relative volatilities. This paper tries
to explain why the Fed has been treating the two cycles so differently. To address
this issue, I first construct a monetary growth model which replicates the seasonal and
cyclical patterns of aggregate U.S. data. Then I use the model to compare the historical
U.S. monetary policy with two alternative policy rules, namely the constant-interest-rate
rule proposed by Carlstrom and Fuerst (1996), and the constant-money-growth
rule advocated by Friedman (1959, 1982). Both alternatives are constrained to generate
the same seigniorage revenue as the historical policy. Numerical simulations show that
(l)the model captures both the real and nominal features of U.S. data quite well and
it outperforms traditional cash-in-advance models in replicating the nominal variables;
and (2) the historical monetary policy attains higher welfare than both alternatives. It
is demonstrated that the model's success on the nominal side is attributable to the assumption
of consumption durability and the introduction of a shock to the transaction
technology. It is argued that the findings from the welfare experiments extend Poole's
(1970) insights to a dynamic and stochastic environment, and that these findings suggest
that the Fed has been sensibly choosing its monetary policy in response to seasonal
swings and business cycle fluctuations, rather than creating exogenous disturbances to
Liu, Z., (1996), "Seasonal Cycles, Business Cycles, and Monetary Policy", Discussion Paper No. 292, Center for Economic Research, Department of Economics, University of Minnesota.
Seasonal Cycles, Business Cycles, and Monetary Policy.
Center for Economic Research, Department of Economics, University of Minnesota.
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