successfully after 1979, beginning under fed chairman volcker. better known than even the taylor curve is john taylor ’ s famous taylor rule, a simple equation that has proved remarkably useful as a rule - of - thumb description of monetary policy ( taylor, 1993 ). in its basic form, the taylor rule relates the federal reserve ’ s policy instrument, the overnight federal funds interest rate, to the deviations of inflation and output from the central bank ’ s desired levels for those variables. estimates of the taylor rule for the late 1960s and the 1970s reflect the output optimism and inflation pessimism of the period, in that researchers tend to find a weaker response of the policy rate to inflation and ( in some studies ) a relatively stronger response to the output gap than in more recent periods. 11 as i will shortly discuss further, an insufficiently strong response to inflation let inflation and inflation expectations get out of control and thus added volatility to the economy. at the same time, strong responses to what we understand in retrospect to have been over - optimistic estimates of the output gap created additional instability. as output optimism and inflation pessimism both waned under the force of the data, policy responses became more appropriate and the economy more stable. in this sense, improvements in policymakers ’ understanding of the economy and the role of monetary policy allowed the economy to move closer to the taylor curve ( or, in terms of figure 1, to move from point a to point b ). improved monetary policy or a shifting taylor curve? improvements in monetary policy that moved the economy closer to the efficient frontier described by the taylor curve can account for part of the great moderation. however, several empirical studies have questioned the quantitative importance of this effect and emphasized instead shifts in the taylor curve, brought about by structural change or good luck. for example, in a paper presented at the see, for example, judd and rudebusch ( 1998 ), taylor ( 1999 ), clarida, gali, and gertler ( 2000 ), cogley and sargent ( 2002 ), and mehra ( 2002 ). orphanides ( 2003 ) argues that, if one takes account of policymakers ’ mis - estimates of the output gap in the 1970s, the same taylor rule that describes policy after 1979 applies to the 1970s as well. the debate is an important one, but it may bear more on what policymakers actually thought they were doing - and thus on the history of ideas - then on the question

##t and the u. s. current account deficit, ” homer jones lecture, april 14, 2005, and “ reflections on the yield curve and monetary policy, ” economic club of new york, march 20, 2006. “ recycling petrodollars, ” matthew higgins, thomas klitgaard, and robert lerman, current issues in economics and finance, vol. 12, no. 9, federal reserve bank of new york, december 2006. these figures, as in table 1, refer to changes in current account balances for selected developed and emerging - market economies based on recent estimates in the international monetary fund ’ s world economic outlook ( september 2006 ). except for a statistical discrepancy and a typically small capital account balance, a country ’ s current account balance approximates its financial account balance – the difference between domestic net purchases of foreign financial assets and foreign net purchases of domestic financial assets. pullback ) of capital controls in thailand. but the effects on broader markets appear to have been remarkably contained. even the episode last year involving the hedge fund, amaranth, which accumulated losses of $ 6 billion in a few short weeks, seemingly had little impact beyond its direct stakeholders. it is hard to know with certainty when investors ’ confidence will be stirred – but not shaken – by these events. it is harder still to know precisely why. i have argued that solid fundamentals – effective and dynamic products and markets to disperse risk, stable economic performance, and robust and attractive market infrastructures – are key underpinnings for strong liquidity and correspondingly strong investor confidence. surely, policymakers must be vigilant to maintain output stability and low and anchored inflation expectations. in addition, policymakers need to encourage sound risk management by private participants as the first line of defense against financial instability. in particular, we should promote policies that encourage stakeholders to engage in ex ante practices, protocols, and principles – including those recently set forth by the president ’ s working group on financial markets – to accomplish that objective. of course, investor confidence and liquidity can shift. in the aftermath of a financial shock, if buyers and sellers of credit can no longer agree on the distribution of possible outcomes, their ability to price transactions will be severely limited. while we cannot – and often should not – prevent all shocks or predict how they will reverberate through the financial system, we can attempt to create conditions that would lead investors to most quickly rebuild their confidence. that is most likely