Forward-Looking Behavior and the Optimality of the Taylor Rule

Abstract

This paper examines the optimal monetary policy under discretion using a small macroeconomic model that allows for varying degrees of forward-looking behavior. We quantify how forward-looking behavior affects the optimal response to inflation and the output gap in the central bank's interest rate rule. Specifically, we isolate the influence of forward-looking behavior in the aggregate demand equation, the wage contracting equation, and the term structure equation. We show that the data cannot uniquely identify the degree of forward-looking behavior in this class of models. Nevertheless, by imposing some assumptions about forward-looking behavior that are motivated by economic theory, we show that a plausible set of parameters can deliver the Taylor rule as the optimal monetary policy under discretion. We find that a successful parameter combination must include one or more of the following: (i) a high degree forward-looking behavior in the aggregate demand equation, (ii) a low degree of forward-looking behavior in the term structure equation, or (iii) a large (but still plausible) interest rate sensitivity parameter in the aggregate demand equation. More generally, our results show that a plausible set of model parameters can erase the distinction between instrument rules (such as the Taylor rule) and so-called targeting rules that represent the solution to a particular loss-minimization problem assigned to the central bank.