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A driving analogy is sometimes used to illustrate the problems of the Fed. In the best of all worlds, we would drive a car in perfect weather along straight, wide, dry roads. We would look out crystal clear windows with complete knowledge of exactly where we are on the road and what driving conditions are like up ahead. Then, with complete control over the car, we could adjust speed and direction to reach our destination.
This is not the right picture for monetary policy. Instead, the windshield is very dirty, obscuring current conditions and making predictions almost impossible. Although the driver is well trained, the connection between the tools of the car and its direction and speed is haphazard.
Suppose the driver sees a steep downhill in the distance that requires some slowing down. Putting on the brakes will eventually slow the car down, but the delay is hard to predict. Making matters worse, by the time the car slows, the road may be going uphill again.
More precisely, the first challenge for the Fed is determining the current state of the economy. The Fed must rely on economic data to determine the current state of the economy. This is not easy; data often arrive with lags and with measurement error. Furthermore, the data often provide conflicting signals about the current state of the economy.
The second challenge for the Fed is that the transmission mechanism is not cast in stone. Reducing real interest rates by, say, one percentage point does not create the same response in spending at all times. Instead, the links in the monetary transmission mechanism change over time and depend on numerous other variables in the economy. Understanding these links remains a key area of research in economics and is also a challenge for those responsible for the conduct of monetary policy.
History of money
Consider a Taylor rule given byreal interest rate = −(1/2) × (output gap) + (1/2) × (inflation rate − 4 percent).
Get data on the US economy to see how well the Taylor rule,real interest rate = −(1/2) × (output gap) + (1/2) × (inflation rate − 4 percent),
fits the facts for the past five years.