Optimal Reaction Functions, Taylor's Rule and Inflation Targets: The Experiences of Dollar Bloc Countries

Abstract

The central banks of Canada, New Zealand, Australia, and the seem to have adopted somewhat different approaches to controlling inflation. This paper focuses on the empirical issue of whether a particular central bank can be said to be implementing a strict or a flexible inflation targeting policy. We test this for what we refer to as the dollar bloc countries by constructing and estimating small macro-models, whose parameter estimates we use to compute optimal reaction functions. These are then compared to empirically estimated reaction functions (extended Taylor rules) that the respective dollar bloc countries appear to have used since 1988. Our results indicate that, for the most part, dollar bloc central banks have had much in common. We find strong evidence that none of the central banks target inflation strictly (in the sense of Svensson). Our results suggest that the central banks control inflation as if they rely heavily on interest rate smoothing, but may place little weight on output variability. Nonetheless, we do find some differences in the policies pursued by each of the central banks. Timing and magnitudes of policy moves have differed. In particular, we find little evidence of a made in the US monetary policy. In addition, we find some differences in how the central banks of Canada, Australia and New Zealand reacted to exchange rate movements.