Monetary Policy Switch, the Taylor Curve, and the Great Moderation

Abstract

This paper employs a standard new Keynesian model to compute the inflation/output volatility frontier, i.e. the Taylor curve. We find that under indeterminacy the tighter is the monetary policy, the higher is the inflation/output gap volatility. This is due to impact of systematic monetary policy on inflation and output persistence in the model. In fact, under indeterminacy a more aggressive monetary policy causes an increase in inflation persistence, and augments its volatility .T he effects on output tend to be of opposite sign. When moving to ’active’ monetary policies the degrees of inflation and output persistence in the model drop remarkably. This finding is robust to different parameterizations of the DSGE new-Keynesian monetary model employed. This result i) offers support to the move from ’passive’ to ’active’ monetary policy as one of the possible rationales for the Great Moderation, ii) underlines the need of a deeper understanding of the link between systematic monetary policy and macroeconomic persistence, and iii) warns against subsamples pooling when performing macroeconometric analysis.