In the model sketched above this interest rate can be

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Unformatted text preview: cular, of changes in Suppose interest-rate 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 interest-rate 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 well-known 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. In...
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