Three Equation Macro Model Simulation

Three Equation Macro Model Simulation

The Central bank of the United States known as the Federal Reserve is responsible for promoting financial stability, regulating banks and providing financial services to the US government and depository institutions. Yet, according to the Federal Reserve Act of 1977, one of the main objectives of the Federal Open Market Committee (FOMC) is to conduct the monetary policy which meets the policy objectives set by the US congress, namely, "promotes effectively the goals of maximum employment, stable prices, and moderate long-term interest rates" (Federal Reserve History).

This paper firstly offers a brief overview of monetary policy in the United States. Then, it employs simulations based on the Three equation

It is the rate at which depository institutions borrow and lend from one another in the federal funds market. The FOMC’s open market operations lower the rate by increasing the reserves supplied to the economy, or alternatively, raise the rate by reducing the supply of balances. Due to a term structure of interest rates, the changes in the short-term interest rates are transmitted to the long-term interest rates since the financial markets expect the changes to persist for an extended period of time or assume that they convey information about the future monetary policy. Also, the inflation inertia ensures that the change in the federal funds rate effectively influences the real interest rate which is equivalent of the cost of borrowing. By altering the cost, federal funds rate indirectly affects the spending and investment by households and businesses, which on their turn, impact output and inflation in the economy.

The dynamic Three Equation Macro Model designed by Charles I. Jones allows us to trace the behavior of the Fed’s monetary policy and other economic variables over time when the economy is exposed to different kinds of shocks. The model incorporates IS curve along with the Phillips curve and the Taylor Rule, assuming the adaptive inflation

The simulations give rise to the impulse functions that describe the behavior of endogenous variables such as the monetary policy rate, change in real GDP and inflation over an extended period of time in response to the initial shocks. Figure 4, 5 and 6 display the impulse functions of R_t , (y_t ) ̃ and π_t with respect to the negative demand shock, particularly to the burst of housing bubble and corresponding reduction in a_t parameter. Figure 4 shows that the monetary policy responded to the shock by a sharp decrease in R_t followed by a gradual increase to prevent the economy from overheating. Reduction in R_t makes intuitive sense: since the negative demand shock reduced the output, the Fed lowered the real interest rate to stimulate investment and make up for the reduction in a_t parameter. It is also interesting to note that once the output gap turned positive, R_t began rising to keep output at the potential. Figure 5 shows that aggregate demand shock caused a sharp decrease in the real output gap which reached the minimum in the first quarter and started to increase gradually due to the reduction in the monetary policy rate. Similar to R_t, real GDP gap adjusted fairly quickly, in about four-five quarters. Figure 6 displays slow