Interpreting the Significance of the Lagged Interest Rate in Estimated Monetary Policy Rules

William B. English 1 , 1 , William R. Nelson 2 , 2  and Brian P. Sack 3 , 3
  • 1 Bank for International Settlements, william.b.english@frb.gov
  • 2 Board of Governors of the Federal Reserve System, william.r.nelson@frb.gov
  • 3 Board of Governors of the Federal Reserve System, brian.p.sack@frb.gov

Many researchers have found that the lagged interest rate enters estimated monetary policy rules with overwhelming significance, suggesting that policy adjusts gradually to changes in economic conditions. However, Rudebusch (2002) argues that the lagged interest rate is not a fundamental component of the U.S. policy rule, and that its significance arises from the omission of serially correlated variables from the policy rule. This paper considers the possibility that policy rules may be characterized by both partial adjustment and serially correlated omitted variables. Our findings indicate that even if one allows for serially correlated errors, partial adjustment plays an important role in describing the behavior of the federal funds rate.

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The B.E. Journal of Macroeconomics publishes significant research and scholarship in theoretical and applied macroeconomics. The range of topics includes business cycle research, economic growth, and monetary economics, as well as topics drawn from the substantial areas of overlap between macroeconomics and international economics, labor economics, finance, development economics, political economy, public economics, econometric theory.

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