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It was designed to
provide “recommendations” for how a central bank like the Federal Reserve should set
shortterm interest rates as economic conditions change to achieve both its shortrun goal
for :stabilizing the economy and its longrun goal for inflation.
Specifically, the rule states that the “real” shortterm interest rate (that is, the interest rate
adjusted for inflation) should be determined according to three factors: (1) where actual
inflation is relative to the targeted level that the Fed wishes to achieve, (2) how far economic
activity is above or below its “full employment” level, and (3) what the level of the shortterm
interest rate is that would be consistent with full employment. The rule “recommends” a
relatively high interest rate (that is, a “tight” monetary policy) when inflation is above its target
or when the economy is above its full employment level, and a relatively low interest rate
(“easy” monetary policy) in the opposite situations. Sometimes these goals are in conflict: for
example, inflation may be above its target when the economy is below full employment. In
such situations, the rule provides guidance to policy makers on how to balance these
competing considerations in setting an appropriate level for the interest rate.
Although the Fed does not explicitly follow the rule, analyses show that the rule does a fairly
accurate job of describing how monetary policy actually has been conducted during the past
decade under Chairman Greenspan. This fact has been cited by many economists inside
and outside of the Fed as a reason that inflation has remained under control and that the
economy has been relatively stable in the US over the past ten years.
Transmission mechanism of monetary policy
The Monetary Policy Committee (MPC) sets the shortterm interest rate at which the central
Bank deals with the money markets. Decisions about that official interest rate affect
economic activity and inflation through several channels, which are known collectively as the
'transmission mechanism' of monetary policy.