Is the Taylor rule optimal? Evaluation using a wavelet-based control model

Abstract

ABSTRACT This paper extends the wavelet-based control (WBC) model of Crowley and Hudgins (2015) to compare the simulated performance of jointly optimal fiscal and monetary policy, where the policymakers place emphasis on a variety of macroeconomic targets, with the case where monetary policy follows a modified Taylor rule. The results show that the Taylor rule is likely to render higher interest rates, diminished investment, and appreciated real exchange rates compared with an unconstrained baseline simulation. We therefore find that the Taylor rule is suboptimal since it results in higher fiscal deficits due to substitution by policy authorities, thus confirming recent research on the interaction of fiscal and monetary policies. The analysis also compares the baseline and Taylor rule simulated forecasts when the central bank adopts a ‘hawkish’ inflation policy compared to a more ‘dovish’ policy stance.