Seasonal Cycles, Business Cycles, and Monetary Policy

Abstract

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 the economy.