Revealed Preference of the Federal Reserve: Using Inverse-Control Theory to Interpret the Policy Equation of a Vector Autoregression.

How close is observed Federal Reserve policy to policy that would be optimal in the control theory sense? This question is addressed by using an inverse control methodology. Federal Reserve policy is characterized by a feedback equation for either changes in the interest rate or money stock. Optimal policy is characterized by solution of the Ricatti equation. Parameters are estimated that characterize the relative importance to the Fed of stabilizing output, inflation, interest rates, and money growth. The period of study is 1947 through 1992. Evidence is uncovered that policy is optimal within distinct regimes.