Similar changes were happening elsewhere. On 16 th September 1992, British interest rates and foreign exchange reserves were used in a futile effort to retain membership of the European Exchange Rate Mechanism with adverse consequences for housing foreclosures and Conservative Party re-election chances. King (2000, 2) believes that this episode facilitated a central banking revolution in the UK: “there are moments when new ideas come into their own. This was one of them … We decided to adopt and formalize a … commitment to an explicit numerical inflation target”. Thus, a failed monetarypolicy was followed by transparency (1993, Inflation Report by the Bank of England) and Bank independence (May 1997). The TaylorRule has become a key conceptual framework in a central banking environment committed to time- consistency (credibility-commitment), transparency and (varying degrees of) independence.
The analysis of the performance of the Taylorrule in the rest of Accession Countries to EU for which there are available data (Estonia, Latvia, Slovenia and Cyprus) would not be appropriate. In Estonia, the exchange rate system for the 1992-2003 period was the currency board. The Latvian case is very similar to its northern neighbours and the main objective of its monetarypolicy is to maintain a fixed parity against a basket of currencies (a conventional fixed pegs). Finally, Cyprus had a fixed pegs system during the 1991-99 period and adopted an horizontal bands system in 2000. In these countries it would not be appropiate to consider the Taylorrule given their economic characteristics. As we know, the more fixed the exchange rate is the more endogenously determined monetarypolicy is. Thus, I analyse the Slovak Republic case where a crawling band exchange system was employed for the 1996-97 period and a managed float regime after 1997. In this country we have a slightly flexible exchange rate.
Discretionary monetarypolicy suﬀers from an ineﬃciency. Since policy cannot com- mit to stabilize future in ﬂ ation, in ﬂ ation will be too volatile relative to the commit- ment outcome. This paper showed that the stabilisation bias can be mitigated if the central bank, besides stabilizing in ﬂ ation and output gap variability per se, also aims at minimizing deviations of the policy instrument from the interest rate level prescribed by a Taylorrule. Monetarypolicy should be delegated to a central banker or a monetarypolicy committee, respectively, that puts a small weight on the Taylorrule. If roughly one quarter of committee members set interest rates according to a Taylorrule and the remaining three quarters set policy optimally based on standard principles, the welfare loss is minimized.
To fight great recession, policy makers would have favored negative interest rate but the federal funds rate could not fall below zero and therefore, the Fed resorted to the policy of quantitative easing. The policy makers became disenchanted with the Taylorrule and pointed out the weakness of the rule. In particular, it was mentioned that the output gap and the real equilibrium interest rates are not observable and their estimation is a real complicated task. The Taylorrule is not strictly implementable on theoretical as well as operational grounds. According to Ben Bernanke, monetarypolicy making is quite complex, particularly in a dynamic economy such as the U.S.
between the two central banks. Based on the special features of the partial VECM and the general VEC model, we are able to identify interdependence in the long-run cointegrating equations and evidence of short-run interest rate smoothing dynamics in the error correction framework (Judd and Rudebusch, 1998). Both the partial VECM and the general VECM pay good attention to the non-stationarity of the time series variables, which has been too often ignored in earlier TaylorRule estimations (Gerlach-Kristen, 2003). Hence, interest rate rules estimated using the cointegration approach are, in contrast to the traditional Taylorrule stable in sample and tend to forecast better out of sample. In addition, in the partial and general VECM frameworks, we are able to test for a leader-follower pattern by checking weak exogeneity of the interest rates in the system. In order to explain the interdependence of monetary policies across the Atlantic, we need to know how the monetarypolicy decisions are made in the euro area and as well as in the U.S. The Taylor reaction function (Taylor, 1993) has been justified by many researchers to be an appropriate framework for describing the monetary policies of the
Taylor (1993) finds that the representative policyrule accurately traces actual monetarypolicy in the United States. It appears an interest rate function with positive weights on the inflation rate and output gap is favored in nearly all countries. Equation (1) indicates that the central bank raises its short term interest rate when the inflation rate exceeds the target level or when output gap is positive. Similarly, Bec et al (2000) note that the nominal interest rates can be regarded as automatic stabilizers as they enable the central bank to meet its target levels. Furthermore, the Taylorrule is useful as it provides an analytical framework which helps central banks in their decision making process. However, Taylor (1993) cautions central banks not to blindly implement the Taylorrule but to use their discretion in applying it, depending on the different situations that prevail.
This paper analyses the Taylorrule and its application to monetarypolicy in the United Kingdom and Euro area. The analysis uses a linear regression on quarterly economic data from 1993Q1 to 2017Q4 for the United Kingdom and 2000Q1 to 2016Q4 for the Euro area. The results show that the Taylorrule does not fully describe the monetarypolicy actions made by the Bank of England and European Central Bank over the period analysed; and, that both central banks engage in a significant level of interest rate smoothing. The results also suggest that the Taylorrule does not provide the rationale for quantitative easing within the two regions and that interest rates should be higher than they currently are.
A BSTRACT : Following the failure of monetary targeting theory in the eighties, several authors have proposed alternatives. The Taylorrule is commonly accepted in recent years for the determination of interest rates in order to achieve the final goal of the central bank. The present study tends to lead an analysis of the compatibility of behavior of central bank of Tunisia (CBT) in the monetarypolicy conduct with the Taylorrule. The results obtained from quarterly data ranging from 1997 to 2011 showed that the original Taylorrule has a low explicative power of the monetary authorities’ behavior in Tunisia. The proposed forward-looking rule describes plausibly interest rates dynamics. In this rule, the money market rate (MMR) is dependent on its past level, the output gap between current and potential output, the deviation of expected inflation from the implicit target, the differential of money market rate between Tunisia and the euro area and the inflation differential between Tunisia and France. Therefore, the Tunisian monetarypolicy can follow a rule based on two main aggregates taken as targets, whose names are inflation and economic growth. The reaction function can be considered as a proposal for a new reform of the monetarypolicy of the Central Bank.
Table 5 presents RMSE estimates for the forecast-based Taylorrule (1b) in first differences. The results are clear-cut. Paralleling the findings for forward-looking Taylor rules, specifications that rely on one year forecasts of the output gap and inflation, and are augmented by lags in a combination of the four asset prices considered, provide the best overall fit among the various specifications. Furthermore, Consensus one year forecasts outperform slightly those based on The Economist while OECD forecasts, which are published only semi-annually, perform most poorly of all. Lastly, there is little deterioration in the in-sample forecasting performance between one and two year-ahead Consensus forecasts. The latter is typically the horizon mentioned by central banks when deciding the appropriate stance for monetarypolicy.
An important aspect of any central bank’s policy is to design an optimal policy framework that would take care of different macroeconomic objectives. In a pioneering work, Taylor (1993) proposed a policyrule for setting bench-mark policy rates in the monetarypolicy. This thumb rule shows how that central bank revises theirs policy rates to different macroeconomic conditions of an economy. Since then numerous literaturehave focused on Taylorrule for the assessment of policy behaviour of central banks (Clarida et al., 2000; Sauer and Sturm, 2003; Hutchison et al., 2010;Kahn, 2012; Beju and Ciupac-Ulici, 2015; Sheel, 2015;Roeskelley, 2016). There are some advantages of following a rule type policy such as avoiding time-inconsistency problems arising from discretion policy and achieving lower uncertainty through greater transparency. Sheel (2015) advocated that the RBI’s monetary stance should be evaluated through Taylorrule. During the late 1990s, the broad objectiv e of India’s monetarypolicy had been to achieve price stability with economic growth (Rangarajan, 2001). But as time passes several developments in macroeconomics emerges as a challenge for the monetary authorities at RBI. In an important note, Mohan (2006)documented that the RBI follows a rebalancing approach between growth and inflation to accommodate various macroeconomic and financial conditions. Later, then governor Reddy (2007) argued that the RBI’s priority for monetarypolicy should be financial stability
It is unlikely that all economic shocks had the same impact in each of the prospective euro area member states before, or even after, EMU. Moreover, at least until the end of 1998, it is likely that these shocks might have elicited different monetarypolicy responses. The behavior of short-term interest rates for three core euro area members, namely France, Germany, and Italy, and a synthetic euro area-wide short-term interest rate prior to 1999, followed by the actual euro area repo rate since 1999, reveals that while convergence in interest rates took place, it only becomes visually apparent the year before the ECB took over responsibility for monetarypolicy in the euro area. Prior to that time, interest rate spreads are sizeable and variable (not shown). Even if interest rate convergence is assumed to have taken place, there is still considerable inflation divergence (e.g., see Busetti et. al. 2006) and this may create difficulties in the long-run for a common currency area and complicate the implementation of a single monetarypolicy.
Regarding the expected variance of inflation, this variable is obviously not directly observable. The data and the methodology used for its construction are discussed in the following subsection. With respect to the real economic activity measure, we use the unemployment gap in place of the output gap. The reason for this choice is twofold. First, because of repeated changes in the base year, no consistent time series of predicted real GDP or GNP can be derived from the Greenbook over the sample (Boivin, 2006). Second, maximum employment is one of the objectives of monetarypolicy clearly written in the Federal Act, thus it is natural to include the unemployment rate directly into the policy function. The unemployment gap is defined as the difference between the natural rate of unemployment and the forecasted unemployment rate so that the sign of the unemployment gap is consistent with that of the conventionally-defined output gap. While the forecast of contemporaneous unemployment rate is collected directly from the Greenbook, the natural rate of unemployment is measured by a 5-year moving average of unemployment rate as in Bernanke and Boivin (2003). We name this proxy the 5-year moving average unemployment gap. The dataset spans the period 1965Q4 to 2007Q4. The start of the sample corresponds to the first period predictions were recorded in the Greenbook. The sample ends prior to the federal funds rate hitting the zero lower bound in 2008.
In the 1920s, the government set a target of restoring the prewar exchange rate with an eye toward lifting the gold embargo at the old parity. However, as exchange rates fluctuated in a de facto gold embargo, the monetarypolicy operated with some consideration for the stabilization of the domestic economy. In other words, although the policymakers set the target of realizing stabilization of exchange rates and free flow of capital in the long run, they sacrificed exchange rate stability in the short term in favor of stability of the domestic economy. This policy stance may be regarded as a sort of managed floating-rate system. In this regard, one observer has commented that “the BOJ was able to become a relief organization because it had effectively continued to halt the conversion of bank notes to gold since the gold embargo was introduced in 1917. Moreover, this was because the government prevented the exchange rate from falling by selling specie money despite the fact that imports continued to exceed exports while gold conversion had been halted.” 15
The signifi cant level of parameter a, which is iden- tifying the preferences of the central bank in con- nection with its infl ation target was analyzed at ECB, Czech National Bank (CNB) and Poland central bank. So in case of ECB we can fully confi rm the fact, that the bank really prefers its primary objective, which is the price stability. The results are not surprising also in the case of the Czech Republic. CNB is in the long term unsuccessful in holding the infl ation within the bands of infl ation target. In some years the value of real infl ation markedly undershot the lower band of infl ation target, and in the year 2004 the rate of infl ation even reached the negative numbers. CNB is also criticized by an array of economist (e.g. Janáček, 1999, Klaus, 2000 or Žídek, 2006) for its too restric- tive policy selected in the period after currency crisis in the year 1997. CNB absolutely univocally prefer- red the aim of price stability at the expense of econo- mic growth stimulation, which according to the above mentioned authors extended the period of economic depression after the currency crisis. The tax for the price stability (Tab. VII) was considerable decelera- tion of the economic growth in the period of years 1998 – 1999 and again in the year 2002. The effort of the polish central bank to lower the double- digit infl ation value in the year 2000 had a similar effect on the economic growth. The growth going over 4% decreased to about 1% (Tab. VII) in the years 2001 and 2002.
We investigate whether the seemingly discretionary and flexible approach of India’s central bank, the Reserve Bank of India (RBI), can in practice be described by a Taylor-type rule. We estimate an exchange rate-augmented Taylorrule for India over the period 1980Q1 to 2008Q4, allowing for potential structural shifts between the pre- and post-liberalization periods in order to capture the potential impact of macroeconomic and institutional changes on the RBI’s monetarypolicyrule. Overall, we find that the output gap seems to matter more to the RBI than inflation, there is greater sensitivity to Consumer Price (CPI) inflation that Wholesale Price (WPI) inflation, and exchange rate changes do not play an important role in constraining monetarypolicy. Moreover, the post-1998 conduct of monetarypolicy seems to have changed in the direction of less inertia.
For the euro area the key message emerging from the table is that monetarypolicy might have been too tight until 2014. The original Taylorrule would have recommended negative policy rates until then. But the ECB was looking at HICP inflation, which was driven partially by oil prices, and even the core HICP (often advocated as a benchmark) did not strip out fully the impact of commodity prices. This explains why the ECB did not try more unconventional measures (like negative rates) during that period.
Based on the previous literature, this paper purposes to estimate the monetarypolicyrule (Taylorrule, Modified Taylorrule, McCallum rule and Modified McCallum rule) for China during the period 1994:1-2006:4. It attempts to find how Chinese monetarypolicy responds to inflation, output gap or nominal GDP growth deviation and which types of Taylorrule and McCallum rule can better describe Chinese monetarypolicy stance. Compared with the related previous literatures, the originality of this paper is the systematically comparative analysis of Taylorrule, Modified Taylorrule, McCallum rule and Modified McCallum rule in context of China. Most of the previous literature regarding Chinese monetarypolicyrule just focus Taylorrule and McCallum rule respectively, not combine them together. Yang (2002) is the only Chinese paper conducting the comparative analysis. In this paper, he just analyzes original Taylorrule and the original McCallum rule. Another novelty of this paper is the systematic analysis of the fundamental contents of monetarypolicyrule. In this paper, the research dynamics, nature, theoretical origin of monetarypolicyrule and the relationship between the policyrule and inflation targeting framework, etc. are well discussed.
Threshold model (2) belongs to the class of regime-switching monetarypolicyrule models. 5 This class of models considers abrupt changes in policyrule parameters beta and gamma which are consistent with recent evidence provided in the literature by many studies. 6 To capture these changes, most of these studies are based on dummy variables intervention approach, or they carry out estimation of the Taylorrule model (3) by splitting the sample into different sub-samples. To determine these sub-samples, this approach relies on exogenous information from the sample. Furthermore, by splitting the sample into sub-samples is like to assume that after a shift in a new regime agents believe that they will stay in this regime permanently. This assumption can not account for the dynamic expectation formation effects of regime-switching monetarypolicyrule models on the economy which can be proved very important and increase the efficiency of monetarypolicy, as aptly noted recently by Davig and Leeper (2007). These effects arise whenever agents’ rational expectations about a future regime change in monetarypolicy induce them to alter their expectations about inflation or economic activity.
As a caveat, our analysis is predicated on the Taylor-rule assumption that U.S. monetarypolicy responds to inflation and the output gap in a linear fashion and that we have accurately measured inflation and the gap as they are perceived by monetarypolicy authorities. To the extent that policymakers respond to other variables or respond nonlin- early or have different perceptions about inflation and the gap, we may be overestimating the instability of policy regimes. For example, if the perceived output gap is strongly asymmetric, being more negative in recessions than positive in expansions, as found in Morley and Piger (2012), we would expect an increase in the estimated response to our linear measure of the output gap during recessions and a decrease in expansions, even if the true response to the gap is stable. Notably, the estimates in Figure 11 for the response to the output gap behave this way, at least in the 2000s. However, a full investigation of more complicated models and additional measures of inflation and the output gap are left for future research. Meanwhile, at least within the linear Taylor-rule framework and assuming our measures of inflation and the output gap do provide a reasonable approximation of the perceptions of policymakers, we find strong support for sizable and interesting changes in the systematic elements of U.S monetarypolicy over the last 40 years.