A Critique of John B. Taylor’s “Expectations, Open Market Operations, and Changes in the Federal Funds Rate”

This article critiques John B. Taylor’s proposal that the Fed use a reaction function to attempt to predict bank demand for reserves. I argue that the Fed does not need to predict the demand for reserves because all the information it requires for hitting its targets is contained in the federal funds rate itself. If the federal funds rate rises above target, the Fed must supply reserves; when it falls below target, the Fed must drain them. Further, although Taylor sometimes seems to recognize that the overnight interest rate is necessarily an exogenous variable, set by the Fed, and that reserves are a nondiscretionary variable, he appears to believe that this is due to particular accounting rules now in place. I argue that whether the Fed operates with lagged reserve accounting or contemporaneous reserve accounting, reserves are never discretionary and the federal funds rate need always be exogenously administered.