The Determinants of Federal Reserve Discount Rate Policy

Abstract

In comparison to private sector behavioral functions, the quantitative explanation of policymakers' behavior has been subject to relative neglect.' In the case of the determinants of the discount rate, the neglect has been complete. The present paper provides a statistical explanation of Federal Reserve discount rate-setting policy. A discount rate is specified and tested on data from the postwar period.2 A discount rate reaction function may provide useful evidence on a number of important questions. In its explanation of discount rate policy and its announcements of discount rate changes, the Federal Reserve indicates that discount rate policy is aimed at the achievement of a multiplicity of goals. These include the financial goals of the system as well as the broader goals of overall macroeconomic stabilization policy.3 It is clear that conflicts arise in pursuit of these goals. As has been pointed out by Carson [7, 61], Burns [6, 49], and Polakoff [28, Section II], however, the Federal Reserve Board has failed to confront, or at least has failed to explain, the process whereby tradeoffs are made in cases of conflicting goals. A discount rate reaction function provides quantitative evidence on the importance of various goal variables in discount rate policy formation.

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