You have all heard about the Taylor rule used for calculating the nominal interest rate set by the Federal Reserve. I am now going to present another rule for determining the Fed funds rate based upon the equations of Effective demand.
Let's get started... We first need to look at the variables that we will use for the rule. We will need the equation for the lower bound of the Fed funds rate as seen in this graph.
The two factors that we need for our rule equation are seen in the following graph.
Ok... let's get some equations going.
Lower bound for TFUR = 0.61 * TFUR - 0.438
Lower bound for effective labor share = 0.61 * els - 0.438
Through some statistical analysis, I arrived at the following equation to determine the Fed rate.
Effective demand rule Fed rate = 0.61*(TFUR2+els2) - 0.438*(TFUR+els) - 2.0%
The 2.0% at the end of the equation is the inflation target.
These variables come straight from the Effective Demand equation.
Effective Demand = real GDP * els/TFUR
The graph of this equation since 1988 looks like this.
The Brown line is what we are calculating. It has some noise, so I added a 3-month average to smooth it out. The Effective demand rule is based on an inflation target of 2.0%. The line deviates from the actual Fed rate, but trends more steadily through the business cycle. We can see that now the equation is still showing a negative Fed rate.
I will be using this line in future graphs to analyze the Fed funds rate.