The Output-Gap and Inflation Volatility Trade-off: Do External Shocks and Inflation Expectations Shift the Taylor Curve

Abstract

Do inflation expectations, external and uncertainty shocks shift the Taylor curve? Evidence shows that a positive Federal Funds Rate (FFR) shock leads to a delayed increase in the repo rate, a decline in the repo rate-FFR rate spread and the deterioration in the current account. Foreign economic policy uncertainty shocks result in the increase in the domestic Taylor curve and, in turn, the increased gross capital outflows magnify the Taylor curve responses to elevated economic policy uncertainty shocks. The inflation and output-gap volatilities increase following a positive inflation expectations shock. A positive inflation expectations shock when inflation expectations are above 6 per cent increases the Taylor curve. On the other, inflation expectations have absolutely no effect on the Taylor curve when inflation expectations are below 6 per cent. Elevated and unanchored inflation expectations induce a shift in the Taylor curve. However, evidence shows that inflation expectations below 4.5 per cent minimise the output-gap and inflation volatilities.