Top PDF How useful are Taylor rules for monetary policy?

How useful are Taylor rules for monetary policy?

How useful are Taylor rules for monetary policy?

challenge of monetary policy is to interpret current data on the economy and financial markets with an eye to anticipat- ing future inflationary or contractionary forces and to coun- tering them by taking action in advance.” Governor Meyer (April 24, 1997) noted that he is “inclined to believe in the forward-looking approach and therefore in preemptive pol- icy.” Moreover, he justified forward-looking policy in his comments on March 16, 1998, that “[a] good reason for responding to forecasts of inflation is that the effects of monetary policy on the economy mostly occur about a year from now.” In a discussion of monetary policy in Canada, Duguay and Poloz (1994) noted that a key implication of the interaction between policy objectives and mainstream views of how the economy works is that policy formulation must be forward-looking. Using Federal Reserve forecasts and preliminary data available at the time policy choices were made, McNees (1986) found evidence that monetary policymaking has been forward-looking as well as back- ward-looking. Orphanides (1997) used Federal Reserve forecasts of inflation to estimate forward-looking policy rules. Clarida, Gali, and Gertler (1998b) estimate for- ward-looking policy rules for pre- and post-1979. Clarida, Gali, and Gertler (1998a) report that Germany, Japan and the U.S. have pursued forward-looking monetary policy. Batini and Haldane (1999) use the Bank of England fore- casting model to show that inflation-forecast-based rules confer some real benefits.
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Monetary Policy Evaluation in Real Time: Forward Looking Taylor Rules Without Forward Looking Data

Monetary Policy Evaluation in Real Time: Forward Looking Taylor Rules Without Forward Looking Data

In order to estimate a central bank’s real-time interest rate reaction function, it is crucial to develop real-time forecasts of the inflation rate and the output gap when this data is not available. The Greenbook U.S. output gap forecast can be well described by a simple quadratic detrending, while many other popular detrending methods produce results significantly different from the Fed’s internal estimates. Greenbook inflation forecasts can be closely replicated using Bayesian model averaging over various lag lengths of the ADL model in inflation and the GDP growth rate. Other aggregate methods also typically produce forecasts superior to single model projections. The paper proceeds to use these forecasts in order to estimate forward-looking Taylor rules in the absence of forward-looking data. The results show that since the 1980s, the Fed, the Bank of Canada, the Bundesbank, and the Bank of England have pursued inflation- targeting monetary policy. However, while the United States and Germany targeted inflation one-year-ahead, the United Kingdom and Canada focused on the middle-term of roughly two quarters hence. Despite these differences, all four central banks obeyed the Taylor principle of having an inflation response coefficient greater than one.
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UK Monetary Policy Reaction Functions, 1992-2014: A Cointegration Approach Using Taylor Rules.

UK Monetary Policy Reaction Functions, 1992-2014: A Cointegration Approach Using Taylor Rules.

considered indicative of the Taylor rule as a description of monetary policy, and with this in mind, the following sub-periods be identified for the UK. With such an erratic history, it is of interest whether the effectiveness of British monetary policy has changed in a significant way. Taylor (1993) introduced a positive metric for determining the goals of monetary policymakers, expressed in simple interest-rate reaction functions as well as normative rules for judging the effectiveness of policy, particularly through an analysis of the magnitude of the coefficients on the reaction function. Since then, the literature on Taylor Rules has expanded considerably and various authors have estimated Taylor-type reaction functions for a wide cross-section of countries. Prior approaches to estimating Taylor Rules, whether in the UK or more generally, either tend to estimate a single rule for long time periods, or exploit the narrative history to identify changes in announced central bank policy and estimate separately for each period. The first approach ignores the possibility of structural breaks in the monetary policy reaction function and risks biased coefficients on the parameters of interest. The second approach offers an improvement by acknowledging the possibility of structural change in the reaction function, but implicitly assumes that the change in actual policymaking occurs at the moment of the announcement of a change in policy. However, it is plausible that these two events may occur with a lag: an announced change in policy may reflect a change in de facto policymaking some quarters prior, or an announced change in policy may only be implemented with a These possibilities pose serious challenges to the determining the timing of breaks in sub-periods. For estimations purposes then, sub-periods for estimation might follows as Nelson (2002), Adams et al (2005) and David (2011):
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What Is Wrong with Taylor Rules? Using Judgment in Monetary Policy through Targeting Rules

What Is Wrong with Taylor Rules? Using Judgment in Monetary Policy through Targeting Rules

Laubach, Mishkin and Posen [7]). Thus, there has been commitment to objectives rather than to simple instrument rules. Second, central banks have developed very elaborate and complex decision-making processes, where large amounts of information are collected, processed and analyzed, and where considerable judgment is exercised (see, for instance, Brash [13]). Third, any simple rules of thumb actually used are conditions for target variables or forecasts of target variables, rather than explicit formulas for the instrument rate. This is the case, for instance, for the rule of thumb expressed by the Bank of England and Sveriges Riksbank (the central bank of Sweden), that normally, the interest rate should be adjusted such that the resulting inflation forecast at an appropriate horizon (usually about two-years ahead) is on target. 5 No central bank has so far made a commitment to a simple instrument rule like the Taylor rule or variants thereof. Neither has any central bank announced a particular instrument rule as a “guideline.” Thus, there appears to be a substantial gap between the research on instrument rules and the practice of monetary policy. This paper discusses and proposes a way to bridge that gap. From a descriptive perspective, it argues that, in order to be useful for discussing real-world monetary policy, the concept of monetary-policy rules has to be broadened and defined as “a prescribed guide for monetary-policy conduct,” including “targeting rules” as well as “instrument rules.” 6 Furthermore, it argues that the monetary-policy practice is better discussed in terms of targeting rules than instrument rules. A general targeting rule specifies the objectives to be achieved, for instance, by listing the target variables, the targets (target levels) for those variables, and the (explicit or implicit) loss function to be minimized. A specific targeting rule specifies conditions for the target variables (or forecasts of the target variables), for instance, like the above rule of thumb of the Bank of England and the Riksbank. From a prescriptive perspective, this paper argues that a commitment to targeting rules has a number of advantages, for instance, in 5 This rule furthermore refers to constant-interest-rate forecasts, since both the Bank of England and the Riksbank mainly rely on such forecasts.
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Monetary Policy in Europe: Evidence from Time-Varying Taylor Rules

Monetary Policy in Europe: Evidence from Time-Varying Taylor Rules

This paper is structured as follows. In Section 1 the existing literature on time- varying monetary policy rules is reviewed. Theoretical models based on asymmet- ric central-bank preferences imply a time-varying reaction to economic variables. Though empirical research on this topic is still in the beginning, non-linearities in monetary policy rules seem to be of importance. Section 2 discusses the specification of the Markov-switching model and the estimation procedure. It is assumed that the monetary policy regime switches according to a first-order Markov process, while a second independent Markov process determines switching in the residual variance of the monetary policy rule. The countries investigated are France, Germany, Italy, the United Kingdom and the United States. Section 3 discusses the data and Section 4 presents the estimation results. Results show that the weights assigned to inflation and the output gap follow two distinct regimes. The first monetary policy regime is associated with a high weight on inflation, while in the second regime the central bank follows an accommodative policy. Following the terminology of Owyang and Ramey (2000) one regime can be classified as “hawkish” because a high weight on inflation is associated with a low one on output, whereas the other regime can be termed as “dovish” with a high weight on output and a low weight on inflation. In addition, the consequences of participation in the EMS for France and Italy are explored. Switching in the residual variance is relevant for all countries and con- tributes significantly to an improvement over a simple linear model. Results are found to be robust against changes in the definition of expected inflation and the output gap. Section 5 concludes.
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The Difficulty of Discerning What's Too Tight: Taylor Rules and Japanese Monetary Policy

The Difficulty of Discerning What's Too Tight: Taylor Rules and Japanese Monetary Policy

With BoJ policy under intense scrutiny in recent years, it is no surprise that there have been many efforts to use reaction function analysis to assess its reaction to the onset of the recession early in the decade. There is little agreement among these studies, however: Some find that the BoJ was too tight over this period, while others suggest its reaction was appropriate, or even that the call rate was set too low. Even those who agree that BoJ policy went from being “too loose” in the late 1980s to “too tight” in the early 1990s differ considerably as to exactly when the change took place. The variety of divergent assessments of the Japanese experience illustrates some of the pitfalls, discussed above, regarding the measurement problems inherent in the reaction function approach. In this section, we show that assumptions concerning the output gap are particularly important: Both the specification for the underlying trend in potential output and the use of real-time versus ex-post estimates in the analysis play a role. Whether assessments are made using a forward-looking specification, rather than Taylor’s original backward-looking equation, also makes a big difference in the appraisal.
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Asset Price Momentum and Monetary Policy: Time-varying Parameter Estimation of Taylor Rules

Asset Price Momentum and Monetary Policy: Time-varying Parameter Estimation of Taylor Rules

In an influential paper, Taylor (1993) proposed a simple policy rule for computing the nominal Fed Funds rate. Taylor argued that the nominal Fed Funds rate is the sum of four terms: the real interest rate, the inflation rate; the weighted deviation of inflation from the inflation target and the weighted output gap. Kohn (2007) evaluates this contribution of John Taylor and concludes that “his framework has been enormously important to policymaking in the Federal Reserve, and it has yielded many benefits. Nevertheless, it is important to keep in mind that some significant practical limitations also are associated with the application of such rules in real time. In other words, “it is not so simple to use simple rules” (p.3). Cochrane (2011) gives a comprehensive evaluation of the theoretical foundations of the Taylor Rule and argues that such a rule is not identified without unrealistic assumptions.
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Is the Phillips curve useful for monetary policy in Nigeria?

Is the Phillips curve useful for monetary policy in Nigeria?

The objective of this article is to determine if the Phillips curve is a relevant tool to conduct monetary policy in African countries wishing to adopt an inflation-targeting regime. I choose Nigeria as a case of study because it is in the early stage of the implementation of this regime. I estimate a medium-sized model for monetary policy analysis. The model reflects a synthesis between the New Keynesian and the Real Business Cycle (RBC) approaches. Then I estimate the model by using Bayesian econometric technique in order to overcome the shortage of data availability. The study concludes that there is evidence that central banks can control the inflation rate through a Phillips curve, a Taylor rule that includes the exchange rate, and the sterilization of the resources from oil exports. Nevertheless, there are limits to the stabilization program. The same evidence suggests that it is important to implement a credible inflation- targeting regime to reduce inflation gradually, instead of abrupt stabilization attempts with high costs in lost output.
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What is Wrong with Taylor Rules? Using Judgment in Monetary Policy through Targeting Rules

What is Wrong with Taylor Rules? Using Judgment in Monetary Policy through Targeting Rules

i t|t−1 denotes previous market expectations of the instrument rate, but with a systematic and transparent monetary policy as in current inflation targeting, instrument-rate surprises are small anyhow. In practical monetary policy, there are recent conspicuous deviations from instrument- rate smoothing, in Fed interest-rate reductions in the first half of 2001 and previously Willem Buiter’s voting in the Bank of England MPC. Deviations from Milton Friedman’s (1969) optimal quantity of money could motivate a quadratic interest-rate term (cf. Woodford 1999b), but since most money pays some interest these days, the distortion would seem to be minor, and it is difficult to see that such costs could be significant compared to the costs of variability of inflation and the output gap. Woodford (1999c) has shown that an instrument-smoothing objective under discretion can induce a desirable history-dependence of monetary policy. In the perspective of this paper, though, a commitment to an optimal specific targeting rule is a more direct way of achieving such history-dependence. The practical importance of history- dependence also remains to be established, as noted above. Rudebusch (2002b) suggests that the high coefficient on the lagged federal funds rate in estimated Fed reaction functions can be explained by the Fed reacting to persistent shocks rather than to some separate interest-rate smoothing objective. 56
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Heterogeneous expectations, Taylor rules and the merit of monetary policy inertia

Heterogeneous expectations, Taylor rules and the merit of monetary policy inertia

A potential shortcoming of the aforementioned analyses is the fact that all assume homogeneity of agents in the economy, despite the fact that heterogeneity is a universal feature in reality. Heterogeneity, if captured by structural parame- ters, can have an impact on the dynamics of an economy and affect the dynamic properties of rules. We focus on heterogeneity of expectations in the economy. Agents form either RE or adaptive expectations. In particular, we focus on het- erogeneous expectations in a NK model as elaborated in Branch and McGough (2009). We examine the consequences for local stability when the central bank conducts monetary policy by several simple rules. Thus, the analysis herein may be viewed as a kind of robustness-check for the numerical results of Bullard and Mitra (2002, 2007) mentioned above.
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How useful are monetary policy rules to deal with inflation: The Spanish case.

How useful are monetary policy rules to deal with inflation: The Spanish case.

For the first period (Table III), we obtain signs and coefficients quite close to those expected for the inflation and the output gap, when introducing inflation as an average of backward and forward values (equation III.1). However, the degree of interest rate smoothing is below the expected ( ρ = 0.19). Worse results are found when introducing the monetary aggregate (see III.2) and the exchange rate (see III.3). In the former, inflation does not appear to be significant and the implicit inflation target increases strongly (57.41 versus the 6.68 reference value). In contrast, the monetary aggregate is significant and shows the expected sign. That result would allow us to conclude that the nominal interest rate path might be explained by monetary variables during the first period of our sample. On the other hand, when introducing the exchange rate, all the variables but the exchange rate are significant and show the expected sign. For those reasons is difficult to describe this period by a Taylor rule.
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Using Taylor Rules to Understand ECB Monetary Policy

Using Taylor Rules to Understand ECB Monetary Policy

We conclude that, without assuming a forward-looking attitude of ECB policy-makers, past policy rate changes are identified as having been too small with respect to changes in inflation and the ECB’s policy reaction function does clearly differ from that of the Bundes- bank. However, once forward-looking behaviour of the ECB is taken into account, it has followed a stabilising course, i.e. nominal policy rate changes were large enough to actually influence real short term interest rates. In that case, it becomes more difficult to statistically distinguish between the way the Bundesbank has carried out its mandate of achieving price stability in the nineties and the way the ECB has done it since. Specifications using survey information, and therefore combining a forward-looking aspect with the use of real-time data, result in by far the best fit. Unlike for the US, the use of real-time – instead of ex-post data – does not make such a clear difference for any of our conclusions for the euro area.
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Simple and robust rules for monetary policy

Simple and robust rules for monetary policy

inconsistency principles. His survey also clarified important theoretical issues such as uniqueness and determinacy and he reviewed research on alternative targets and instruments, including both money supply and interest rate instruments. Like McCallum we focus on the robustness of policy rules. We focus on policy rules where the interest rate rather than the money supply is the policy instrument, and we place more emphasis on the historical performance of policy rules reflecting the experience of the dozen years since McCallum wrote. We also examine issues that have been major topics of research in academic and policy circles since then, including policy inertia, learning, and measurement errors. We also delve into the issues that arose in the recent financial crisis including the zero lower bound on interest rates and dealing with asset price bubbles. In this sense, our paper is complementary to McCallum’s useful Handbook of
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Impacts of monetary and fiscal policy interaction on economic growth and inflation, and the Taylor rules in Malaysia, Thailand and Singapore

Impacts of monetary and fiscal policy interaction on economic growth and inflation, and the Taylor rules in Malaysia, Thailand and Singapore

Farrell, 2007). Further, the Taylor rule has been criticised for being too simplistic, as it does not include all of the relevant information needed to conduct monetary policy. An omission that is a likely cause of the misspecification in the estimated reaction functions is only the inclusion of inflation and the output gap. Central banks may have other objectives, such as the maintenance of financial stability or an exchange rate objective which are not included with specific variables used in the Taylor rule. This issue becomes more important for countries where the exchange rate is not flexible and where their governments depend heavily on seignorage revenues due to their inability to generate revenues from other sources and to counter a larger budget deficit (Malik, 2007). Thus, an alternative variable has been included to enhance and better reflect the broader considerations of the central banks. The inclusion of additional or other production or monetary variables may help in a fuller analysis. An interesting point is to estimate if the monetary policy actually pursued can be captured satisfactorily by the estimated specification of the Taylor-type function.
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Monetary Policy Rules in the BRICS: How Important is Nonlinearity?

Monetary Policy Rules in the BRICS: How Important is Nonlinearity?

Although monetary aggregates have been traditionally used as a framework for monetary policy, Nelson (2003) comments that models where the only effect of monetary policy is via the short-term interest rate can be consistent with the quantity theory of money. Laxton and Pesenti (2003) also find that inflation forecast based rules perform better than conventional Taylor rules in small open emerging economies. Not surprisingly, monetary policy in emerging markets has increasingly moved towards inflation targeting and marked-based instruments (Fry et al., 1996).Given that other indicators may also be crucial in emerging markets, the Taylor rule has been extended to accomodate such features. One of such additional elements is the exchange rate (Filosa, 200; Mohanty and Klau, 2005; Devereux et al., 2006; Batini et al., 2009), which supports the “fear of floating” hypothesis. More recently, Mehrotra and Sánchez- Fung (2010) show that McCallum-Taylor specifications with an interest rate instrument and a nominal income gap target perform better than benchmark Taylor rules in describing monetary policy in inflation targeting emerging market economies.
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Flexible monetary policy rules

Flexible monetary policy rules

Several extensions could be considered in the future research. First, in the thesis, we evaluated Taylor-type rules which respond to the current inflation and output gap. Several contributions argue that responding to the past/expected inflation in monetary policy rules might improve welfare (see e.g. Benhabib et al., 2001; Clarida et al., 1998). So an investigation on improving welfare could be conducted by introducing backward/forward specifications of inflation gaps to interest-rate rules. Second, it is worth to introducing the Zero Lower Bound on nominal interest rates when analysing performance of monetary policy rules. As point out by Taylor and Williams (2010) and McCallum (2000), the zero-lower-bound problem might cause monetary policy inefficiency, leading variability on inflation and aggregate demand. An interesting analysis would be investigating how the zero-lower-bound problem affects ranking across different monetary policy rules considered in this thesis. The third extension would be, instead of using interest-rate rules, it would be interesting to consider the exchange rate exclusively in a monetary policy rule. The exchange rate-based monetary policy would be extremely useful for small and extremely open to trade economies (McCallum, 2007) – therefore, explore the potential benefit of rules which take the exchange rate as a targeting variable could be one possible future research.
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Monetary Policy Rules for Convergence to the Euro

Monetary Policy Rules for Convergence to the Euro

In the conditional variance equation, the negative ARCH(1) term for the Czech inflation suggests corrective or offsetting responses to the shocks to volatility in the previous period. The positive ARCH(1) terms for inflation in the remaining two countries would imply propagation of previous-period shocks, but the obtained estimates are not significant. The ARCH(1) term for the exchange rate is significant only in Poland, which is consistent with the pure float mechanism prevailing there. Its negative sign suggests corrective appreciation of previous- period local currency depreciation (or depreciation responding to a prior appreciation). The GARCH(1) terms for the Czech and Polish inflation series are positive, implying inter-period transmission of persistency in volatility. The same term is positive for the Czech and Hungarian exchange rates. It has a negative value for the Polish exchange rate series, implying reverse corrections to the persistency of volatility. It is worth noting that in all examined cases the sums of ARCH and GARCH coefficients do not exceed unity, suggesting an ongoing compression of volatility, or declining risk associated with the time-varying pattern of these variables. This is an important finding for their expected stability in the future and, therefore, for feasibility of application of a policy instrument rule that is based on these indicator variables. It shall be, however, noted that higher order ARMA and GARCH terms would likely yield more robust results, more suitable for forecasting purposes. Nevertheless, from the standpoint of examination of time-varying properties of individual variables their simplified treatment provides some useful information.
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Monetary policy rules and indterminacy

Monetary policy rules and indterminacy

Since John Taylor (1993) estimated the Federal Reserve monetary policy rule, there has been an increasing interest in building the model and the expla- nation of the efficiency of “active monetary policy rules”, that is a police that respond to an increase in inflation more that one-to-one increase in nominal interest rate. The basic idea is that in order to get a unique stable solution, poli- cymakers should use active monetary policy taking into account current infla- tion (Kerr and King, 1996) or future inflation expectations (Bernanke and Woodford, 1997; Clarida, Gali and Gertler, 2000).
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Monetary policy rules and indterminacy

Monetary policy rules and indterminacy

Since John Taylor (1993) estimated the Federal Reserve monetary policy rule, there has been an increasing interest in building the model and the expla- nation of the efficiency of “active monetary policy rules”, that is a police that respond to an increase in inflation more that one-to-one increase in nominal interest rate. The basic idea is that in order to get a unique stable solution, poli- cymakers should use active monetary policy taking into account current infla- tion (Kerr and King, 1996) or future inflation expectations (Bernanke and Woodford, 1997; Clarida, Gali and Gertler, 2000).
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Simple and Robust Rules for Monetary Policy

Simple and Robust Rules for Monetary Policy

We start in the next section with a review of the development of optimal simple monetary policy rules using quantitative models. We then consider the robustness of policy rules using comparative model simulations and show that simple rules are more robust than fully optimal rules. The most recent paper in the Elsevier Handbook in Economics series on monetary policy rules is the comprehensive and widely-cited survey published by Ben McCallum (1999) in the Handbook of Macroeconomics (Taylor and Woodford, 1999). Our paper and McCallum’s are similar in scope in that they focus on policy rules which have been designed for normative purposes rather than on policy reaction functions which have been estimated for positive or descriptive purposes. In other words, the rules we study have been derived from economic theory or models and are designed to deliver good economic performance, rather than to fit statistically the decisions of central banks. Of course, such normative policy rules can also be descriptive if central bank decisions follow the recommendations of the rules which they have in many cases. Research of an explicitly descriptive nature, which focuses more on estimating reaction functions for central banks, goes back to Dewald and Johnson (1963), Fair (1978), and McNees (1986), and includes, more recently, work by Meyer (2009) on estimating policy rules for the Federal Reserve.
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