ALTERNATIVE MODELS OF FEDERAL RESERVE BEHAVIOR*

Abstract

IN THIS STUDY, we derive alternative linear decision rules for Federal Reserve and obtain estimates of parameters of these rules. The basic assumptions are: (1) that Federal Reserve acts as if it minimizes a quadratic loss function in certain variables and (2) that Federal Reserve possesses a model of economy. To obtain alternative decision rules, we can either (a) hold (1) constant and vary (2), or (b) hold (2) constant and vary (1). For example, given a quadratic loss function, we derive decision rules conditional on differing views of economic structure. To accomplish this we use concept of an intermediate financial variable (e.g., free reserves or total reserves). It is assumed that Federal Reserve acts through this intermediate variable to affect variables in its loss function. By assuming different intermediate financial variables and different lag structures we obtain alternative models of economic structure. The assumed loss function is minimized with respect to a policy instrument subject to alternative models. The resulting functions are linear decision rules-each conditional on an assumed model. The results suggest that, in each model, operations to stabilize financial markets (defensive operations) were dominant. Evidence is offered that Federal Reserve has, since 1959, responded to balance-of-payments problem while providing for growth in real income (dynamic operations). A clear choice of the intermediate financial variable used by Federal Reserve in 1952-65 period cannot be made; several are equally plausible.