Unformatted text preview: cular, of changes in
Suppose
interestrate spreads. Suppose that one’s goal is to set a value of the policy rate at each
point in time that is consistent with output equal to potential (or, more precisely,
the “natural rate of output” in the sense of Friedman, 1968). In the model sketched
above, this interest rate can be determined at any time given two other numbers:
1) the current value of the “natural rate of interest”—the real interest rate required
for
for output equal to the natural rate, in the absence of financial frictions15—converted
—converted
into an equivalent nominal interest rate by adding the current expected inflation
rate, and 2) the current interestrate spread ω.16
The
The model therefore suggests that changes in credit spreads should be an
important indicator in setting the federal funds rate; the funds rate target should be
lower than would otherwise be chosen, given other conditions, when credit spreads
are larger. John Taylor (2008) has proposed, in this spirit, that his wellknown
rule for setting the federal funds rate target (explained in Taylor, 1993) should
be modified to specify a funds rate target equal to that prescribed by the standard
“Taylor rule” minus the current value of the LIBOR–OIS spread shown in Figure 5.
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 Spring '10
 BATCHELDER
 Macroeconomics, Interest Rates, Monetary Policy, Supply And Demand, The Land, Journal of Economic Perspectives

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