A modified Taylor rule for dealing with demand shocks and uncertain potential macroeconomic output

Abstract

A critical issue for central banks in modern economies is the inflation stabilization about a prescribed level. The best-known simple instrumental rule to guide monetary policy to control inflation is the Taylor rule, where the instrument (e.g., a short interest rate) responds to changes in the inflation and the output gaps. The objective of this paper is to introduce some modifications to the Taylor rule in order to improve its robustness with respect to uncertainties about potential output and unanticipated shocks. To this end, departing from feedback control theory, the Taylor rule is equipped with an adaptive control scheme to reject the adverse effects of shocks and to estimate the deviations of the potential output. It is shown that the proposed adaptation procedure is equivalent to a classical integral feedback controller whose characteristics and implementation issues are well understood in practical control engineering. Singular perturbation methods are used to establish the stability properties of the resulting control system.