Playing by the Taylor rules or sticking to Friedman's policy: A new approach to monetary policy identification

Abstract

This study develops a novel identification method to analyze key shifts in US monetary policy, contributing to ongoing debates on policy effectiveness and macroeconomic stability. We find that before the mid-1980s, the Federal Reserve adhered to Friedman's policy of a steady money growth, operating with no interest rate smoothing. In contrast, after the mid-1980s, the Fed transitioned to a Taylor rule that incorporated generalized interest rate smoothing and began relying on forward-looking indicators from financial and housing markets. The interest rate smoothing and the use of these indicators helped to reduce inflation and unemployment volatility, with the smoothing potentially reflecting the application of a Kalman-style information filter to improve data processing. Our findings underscore the importance of integrating broader economic indicators and advanced data analysis, which can enhance the Federal Reserve's ability to fight high inflation and support employment without increasing macroeconomic volatility.

Keywords: Great Moderation, Taylor rule, interest rate smoothing, Friedman's policy, housing

JEL Classification: E52, C30, N1, R31