Central Bank Reaction Function Research Articles

A Comparison Between the Fed and the ECB: Taylor Rules

This paper analyzes whether Taylor-type policy rules can be used to describe the behavior of the Federal Reserve and the European Central Bank from the beginning of 1999 until mid 2002. Since there was no common monetary policy for the Euro area before 1999, we examine if the average Central Bank behavior of the countries forming the European Monetary Union can be approximated by a single reaction function. We compare the currency areas by searching for similarities and distinctions between the Taylor-type reaction functions of the two central banks. We pay particular attention to the possible influence of one central bank on the behavior of the other one. The simplest method to test this interdependence is to compare the two reaction functions and try to incorporate the decision variable of one central bank into the other central bank's reaction function. The estimations show that there are significant differences in the reaction functions of both central banks before and after 1999 and between the two central banks. The second result is that the Fed seems to influence the ECB but not vice versa.

Inflation Targeting as a Framework for Monetary Policy: A Cross‐Country Analysis

AbstractThis study makes use of a dynamic Taylor‐type model to examine the conduct of monetary policy by central banks that profess to engage in inflation targeting. Previous research regarding inflation targeting and Taylor‐type rules is reviewed and a dynamic Taylor‐type model is developed. Tests for regime shifts upon the adoption of inflation targeting indicate a significant change in policy in each of the nations in the study for which sufficient data were available. Next, the central bank reaction functions were estimated. Results suggest that most of the central banks conducted a policy of inflation targeting by seeking to contain inflationary pressures rather than reacting to current inflation.

How Forward-Looking is Optimal Monetary Policy?

We calculate optimal monetary policy rules for several variants of a simple optimizing model of the monetary transmission mechanism with sticky prices and/or wages. We show that robustly optimal rules can be represented by interest-rate feedback rules that generalize the celebrated proposal of Taylor (1993). Optimal rules, however, require that the current interest rate operating target depend positively on the recent past level of the operating target, and its recent rate of increase, in a way that is characteristic of estimated central bank reaction functions, but not of Taylor's proposal. We furthermore find that a robustly optimal policy rule is almost inevitably an implicit rule that requires the central bank to use a structural model to project the economy's evolution under the contemplated policy action. However, calibrated examples suggest that optimal rules place less weight on projections of inflation or output many quarters in the future than do rules often discussed in the literature on inflation targeting, or in the current practice of inflation-forecast targeting central banks.

Extending the McCallum monetary policy reaction function for more than two periods

To explain the empirical failure of the expectations hypothesis of the term structure, McCallum [NBER Working Paper, no. 4938 (1994)] proposed a special form of the central bank reaction function. We extend his two-period model in a way, which allows a new interpretation.

Are interest rate regressions evidence for a Taylor rule?

In a variety of recent papers, researchers have found that interest rate behaviour approximately follows a Taylor rule. We show that such interest rate behaviour results when the central bank may be following quite different monetary policy rules from the one proposed by Taylor. In other words, an interest rate relation with output and inflation does not identify a central bank reaction function.

Asymmetric Central Bank Reaction Function: An Application of Smooth Transition Regression

This paper estimates a simple model of exchange rate policy where the Central Bank optimises an objective function which takes into account competitiveness, its commitment to the EMU and the cost of adjustment. We allow for asymmetry in government behaviour whereby a key parameter, the marginal adjustment cost of the effective exchange rate, takes on a continuum of values depending on the value of the DeustscheMark/Irish pound exchange rate. It is shown that he adjustment cost parameter is decreasing in either the level of or the rate change of the DM rate suggesting that the authorities display greater aversion to exchange rate fluctuations as the domestic currency weakens. [C22, F31, F41]

Central Bank Reaction Functions in Inflation and Non-Inflation Targeting Countries: Are They Informative About the Conduct of Monetary Policy?

This paper seeks, through the estimation of central bank reaction functions for 19 OECD countries in a panel setting, to examine the relationship between certain key target variables and an instrument of monetary policy, namely short-term interest rates. A rolling, reduced form, vector autoregression of interest rates, unemployment and inflation rates is employed to mimic a central bank's information set. The results of this study suggest that central banks react in a predictable manner to unemployment and inflation innovations. However, when the group of inflation targeting countries are separately considered, reaction functions are much more informative about both central bank and government motives.

The Canadian Sector of the Multi-Country Model

The quarterly econometric model of Canada described in this paper is based on the prototype model of MCM presented in previous papers and in the forthcoming book, Ths U.S. Economy in an Interdependent World. Few departures from prototype specification were required to represent the functioning of the Canadian economy. The most critical areas for adaptation of the prototype to Canada lay in the financial sector. The Canadian financial system is characterized by close linkage to U.S. financial markets. Condsequently, Canadian interest rates have traditionally moved closely with U.S. interest rates. Because of this linkage, the Bank of Canada, in its RDX2 models, chose to model the process of interst rate determination by postulating a central bank reaction function for the short-term interest rate. Thus, the application of the MCM prototype to Canada represents a departure from accepted procedure for an influential group of Canadian modelers and merits further discussion. The first part of this paper reviews the model's financial sector. The second and third parts present dynamic simulation results and selected multiplier responses that characterize the Canadaian model.