Estimated Taylor Rule Research Articles

Taylor rules around the world: Mapping monetary policy

We estimate Taylor rules for 50 inflation targeting countries around the world. We find that adherence to the Taylor principle is an exception at best. Thus, it seems unlikely that using the interest rate as intermediate target is as widespread as the claims of central banks imply.

The peso problem and dollar hegemony under inflation targeting

This article examines the influence of US monetary policy on Mexico’s exchange rate (peso/dollar) and monetary policy. It shows that the recent reduced volatility of Mexico’s exchange rate is a consequence of defensive policies undertaken by Mexico’s central bank to avoid sudden capital reversals and speculative attacks, usually associated with destabilizing speculative behavior. To test that hypothesis, the paper examines the effect of the accumulation of international reserves and exchange-rate variations on the Mexico–US interest-rate gap. The authors’ findings confirm that international reserves permit the central bank to maneuver the exchange rate and its inflation target. Furthermore, the paper provides an estimated Taylor rule for Mexico, including the US interest rate. The estimation reveals that Mexico’s monetary policy is not independent of US monetary policy. Mexico faces a liquidity trap at a higher interest rate than the United States. Whereas the United States faces a trap at the zero lower bound, Mexico encounters monetary policy ineffectiveness at an interest rate of 3.5 percent.

Assessing uncertainty in the natural rate of interest: Info‐gap as guide for monetary policy in the euro area

AbstractIn this paper, we assume that the natural rate of interest is fundamentally uncertain. Based on a small‐scale macroeconomic model, info‐gap theory is used to rank different monetary policy strategies in terms of their robustness against this uncertainty. Applied to the euro area, we find that an inert or patient monetary strategy is more robust to natural rate uncertainty than a strategy that follows an estimated Taylor rule. An actively responsive monetary strategy is least robust. Our analysis presents a methodology that is applicable in a wide range of policy analyses under deep uncertainty.

Quantifying the Fed’s Objective

The Federal Reserve’s (Fed’s) objective, namely, its dovish stance, is often blamed for the so-called Great Inflation. A popular proxy for the former is constructed using the inflation coefficients in estimated Taylor rules. However, for a welfare-optimizing central bank, the estimated Taylor coefficients are not sufficient for inferring its underlying preference. We quantify Fed’s objective—the targeting rule—relying on a conditional estimator (Gali and Gambetti 2018) that is free of the classical simultaneity problem. We discover that Fed’s targeting rule remained stable during the pre- and post-Volcker periods—the opposite of what is implied through a Taylor rule estimation.

The Taylor principles

We use tests for structural change to identify periods of low, positive, and negative Taylor rule deviations, the difference between the federal funds rate and the rate prescribed by the original Taylor rule. The tests define four monetary policy eras: a negative deviations era during the Great Inflation, a positive deviations era during the Volcker disinflation, a low deviations era during the Great Moderation, and another negative deviations era from 2001 to 2015. We then estimate Taylor rules for the different eras. The most important violations of the Taylor principles, the four elements that comprise the Taylor rule, are that the coefficient on inflation was too low during the Great Inflation and that the coefficient on the output gap was too low during the Volcker disinflation. We then analyze deviations from several alterations of the original Taylor rule. Between 2000 and 2007, Fed policy cannot be explained by any variant of the Taylor rule while, between 2007 and 2015, Fed policy is consistent with a rule where the federal funds rate does not respond at all to inflation and either responds very strongly to the output gap or incorporates a time-varying equilibrium real interest rate.

Fundamental Uncertainty About the Natural Rate of Interest: Info-Gap As Guide for Monetary Policy

In this paper we assume that the natural rate of interest is fundamentally uncertain. Based on a small scale macroeconomic model, info-gap theory is used to rank different monetary policy strategies in terms of their robustness against this uncertainty. Applied to the euro area, we find that a strategy that is responsive to deviations from the policy targets is more robust against natural rate uncertainty than the historical response of the ECB as reflected in an estimated Taylor rule. An inert or passive monetary strategy is least robust. Our analysis presents a methodology that is applicable in a wide range of policy analyses under deep uncertainty.

INTERNATIONAL GREAT INFLATION AND COMMON MONETARY POLICY

We study whether monetary authorities in the G7 countries were changing their responses to inflation in a similar manner during and following the Great Inflation era. We find that the common to the G7 countries inflation pattern during the Great Inflation period could be associated with a common pattern in the monetary policy response to inflation: we find that until the early 1980s monetary authorities in the G7 countries responded mildly to inflation, systematically fought it throughout the 1980s and lessened again their response during the 2000s. The estimated Taylor rule coefficients on inflation are co-integrated, implying the existence of a long-run relationship in the responses to inflation during and after the Great Inflation period. At the same time, principal component analysis of the residuals of the estimated Taylor rules indicates that the shocks' structure cannot account enough for the monetary policies' co-movements. We interpret these findings as suggestive of common monetary policy patterns.

International Great Inflation and Common Monetary Policy

The Great Inflation of the 1970s was an international phenomenon. We study whether monetary authorities in the G7 countries were changing their responses to inflation in a similar manner during and following the Great Inflation era. Our results suggest that the common to the G7 countries inflation pattern during the Great Inflation period is associated with a common pattern in the monetary policy response to inflation. Specifically, first, we find that until the early 1980s monetary authorities in the G7 countries responded mildly to inflation and they systematically fought it throughout the 1980s. Second, we find that the estimated Taylor-rule coefficients on inflation are cointegrated, implying the existence of a long run relationship in the responses to inflation, during and right after the Great Inflation period. We interpret these findings as suggestive of common monetary policy patterns. Third, we conduct a principal component analysis on the residuals of the estimated Taylor rules and conclude that the shocks’ structure cannot account enough for the monetary policies’ comovements. Finally, we find that the response to inflation weakens during the 2000s, indicating that after inflation stabilized in low levels, policy makers are not as concerned with it as they were during the 1980s and 1990s.

The lower bound and the causes of monetary policy inertia: evidence from Sweden

ABSTRACTIn 2009, in the midst of a global recession, Sweden’s Riksbank approached a lower bound on nominal interest rates. This encounter with the lower bound provides a natural experiment for investigating the causes of monetary policy inertia. To exploit this experiment, we estimate Taylor rules with Tobit specifications that permit both interest rate smoothing and persistent shocks (serial correlation) as explanations for inertia. The interest rate smoothing hypothesis leads to a specification in which lagged actual values of the dependent variable appear on the right-hand side of the Taylor rule, while the persistent shocks hypothesis leads to a specification in which lagged values of an unobserved latent dependent variable appear on the right-hand side of the Taylor rule. The divergence of actual and latent dependent variables that occurs at the lower bound provides leverage in distinguishing the two hypotheses. For a conventional Taylor rule, we find evidence of both sources of inertia. For a modified Taylor rule that includes a measure of financial stress, our evidence suggests that interest rate smoothing is the principal source of monetary policy inertia.

Monetary Policy, Trend Inflation, and the Great Moderation: An Alternative Interpretation: Comment Based on System Estimation

What caused the U.S. economy's shift from the Great Inflation era to the Great Moderation era? A large literature shows that the shift was achieved by the change in monetary policy from a passive to an active response to inflation. However, Coibion and Gorodnichenko (2011) attribute the shift to a fall in trend inflation along with the policy change, based on a solely estimated Taylor rule and a calibrated staggered-price model. We estimate the Taylor rule and the staggered-price model jointly and demonstrate that the change in monetary policy responses to inflation and other variables suffices for explaining the shift.

International Great Inflation and Common Monetary Policy

We study whether monetary authorities in the G7 countries were changing their responses to inflation in a similar manner during and following the Great Inflation era. We find that the common to the G7 countries inflation pattern during the Great Inflation period could be associated with a common pattern in the monetary policy response to inflation: we find that until the early 1980s monetary authorities in the G7 countries responded mildly to inflation, systematically fought it throughout the 1980s and lessened again their response during the 2000s. The estimated Taylor rule coefficients on inflation are cointegrated, implying the existence of a long run relation- ship in the responses to inflation during and after the Great Inflation period. At the same time, principal component analysis of the residuals of the estimated Taylor rules indicates that the shocks’ structure cannot account enough for the monetary policies’ comovements. We interpret these findings as suggestive of common monetary policy patterns.

The Taylor Principles

We use tests for structural change to identify periods of low, positive, and negative Taylor rule deviations, the difference between the federal funds rate and the rate prescribed by the original Taylor rule. The tests define four monetary policy eras: a negative deviations era during the Great Inflation from 1965 to 1979, a positive deviations era during the Volcker disinflation from 1979 to 1987, a low deviations era during the Great Moderation from 1987 to 2000, and another negative deviations era from 2001 to 2014. We then estimate Taylor rules for the different eras. The most important violations of the Taylor principles, the four elements that comprise the Taylor rule, are that the coefficient on inflation was too low during the Great Inflation and that the coefficient on the output gap was too low during the Volcker disinflation. We then analyze deviations from several alterations of the original Taylor rule, which identify a negative deviations era from 2000 to 2007 and a low deviations era from 2007 to 2014. Between 2000 and 2007, Fed policy cannot be explained by any variant of the Taylor rule while, between 2007 and 2014, Fed policy is consistent with a rule where the federal funds rate does not respond at all to inflation and either responds very strongly to the output gap or incorporates a time-varying equilibrium real interest rate.

Monetary Policy, Trend Inflation, and the Great Moderation: An Alternative Interpretation: Comment Based on System Estimation

What caused the U.S. economy's shift from the Great Inflation era to the Great Moderation era? {{p}} A large literature shows that the shift was achieved by the change in monetary policy from a passive to an active response to inflation. However, Coibion and Gorodnichenko (2011) attribute the shift to a fall in trend inflation along with the policy change, based on a solely estimated Taylor rule and a calibrated staggered-price model. We estimate the Taylor rule and the staggered-price model jointly and demonstrate that the change in monetary policy responses to inflation and other variables suffices for explaining the shift.

The conduct of monetary policy in the Eurozone before and after the financial crisis

The recent financial crisis of 2007–2009 raises several issues related to the conduct of monetary policy during the last two decades. Inflation targeting monetary strategy has been pointed as a potential source of the crisis, as its main objective of inflation stabilization might have diverted central banks from financial stability. We consider the case of European Central Bank (ECB) inflation targeting monetary policy since its inception in order to provide evidence of possible changes in its implementation after the collapse of Lehman Brothers in September 15, 2008. To this end we take into consideration the existence of nonlinearities that may be present in the estimated Taylor rule specification. We contribute to the recent line of research by estimating Taylor rule models with endogenous structural breaks as well as a Markov-Switching VAR model with endogenous coefficients using quarterly data for the ECB for the period 2001:Q1 to 2013:Q4. The main findings of our analysis show that there is a structural break in the implementation of the monetary policy of ECB during the peak of the financial crisis. Furthermore, we show that the ECB monetary policy followed the Taylor principle during the period before the crisis but did not follow the Taylor rule in the post-crisis period. During the post-crisis the ECB acted less inertially, putting a smaller weight on the inflation gap and shifted its focus on output gap to some extent.

Deviations from rules-based policy and their effects

Rules-based monetary policy evaluation has long been central to macroeconomics. Using the original Taylor rule, a modified Taylor rule with a higher output gap coefficient, and an estimated Taylor rule, we define rules-based and discretionary eras by smaller and larger policy rule deviations, the absolute value of the difference between the actual federal funds rate and the federal funds rate prescribed by the three rules. We use tests for multiple structural changes to identify the eras so that knowledge of subsequent economic outcomes cannot influence the choice of the dates. With the original Taylor rule, monetary policy in the U.S. is characterized by a rules-based era until 1974, a discretionary era from 1974 to 1985, a rules-based era from 1985 to 2000, and a discretionary era from 2001 to 2013. With the modified Taylor rule, the rules-based era extends further into the 1970s and there is an additional rules-based period starting in 2006. We calculate various loss functions and find that economic performance is uniformly better during rules-based eras than during discretionary eras, and that the original Taylor rule provides the largest loss during discretionary periods relative to loss during rules-based periods.

Deviations from Rules-Based Policy and Their Effects

Rules-based monetary policy evaluation has long been central to macroeconomics. Using the original Taylor rule, a modified Taylor rule with a higher output gap coefficient, and an estimated Taylor rule, we define rules-based and discretionary eras by smaller and larger policy rule deviations, the absolute value of the difference between the actual federal funds rate and the federal funds rate prescribed by the three rules. We use tests for multiple structural changes to identify the eras so that knowledge of subsequent economic outcomes cannot influence the choice of the dates. With the original Taylor rule, monetary policy in the U.S. is characterized by a rules-based era until 1974, a discretionary era from 1974 to 1985, a rules-based era from 1985 to 2000, and a discretionary era from 2001 to 2013. With the modified Taylor rule, the rules-based era extends further into the 1970s and there is an additional rules-based period starting in 2006. We calculate various loss functions and find that economic performance is uniformly better during rules-based eras than during discretionary eras, and that the original Taylor rule provides the largest loss during discretionary periods relative to loss during rules-based periods.

Taylor Rules for Sweden's Riksbank

Sweden lapsed into a severe recession in 2008 but, unlike other countries, had a rapid and robust recovery. Because of its unique recession experience, it provides a revealing case for investigating monetary policy responses to macroeconomic fluctuations. We estimate Taylor rules for the Riksbank and for selected individuals who have served on the Riksbank monetary policy committee. Using pre-recession data, our estimates suggest that monetary policy was highly inertial. Estimates for samples including recession and recovery observations reveal more active responses to macroeconomic conditions and weaker indications of inertia. A key feature of our econometric work is the use of a dynamic Tobit specification to account for the lower bound on nominal interest rates encountered during the recession. Comparing alternative empirical specifications for handling the lower bound sheds light on why monetary policy might be inertial.

National representation in supranational institutions: The case of the European Central Bank

Supranational institutions face an important trade-off when hiring personnel. On the one hand, hiring decisions are based, as in most organizations, on a candidate’s professional qualifications. On the other hand, supranational institutions often aim for broad national representation. Reviewing evidence from the European Central Bank, we show that nationality is indeed relevant for both hiring and decision-making. Specifically, we find a disproportionately narrow spread of national representation in the top management of the ECB. Further, there is evidence for the existence of national networks between adjacent management layers. Finally, monetary policy decisions seem to be linked to national representation in the core business areas of the ECB. Examining a sample of 27 European countries over the period from 1999 to 2008, we estimate Taylor rules for alternative sets of euro area aggregates derived from different weighting schemes of national macroeconomic data. Our results indicate that weights based on national representation in the mid-level management of the ECB’s core business areas best describe the central bank’s interest-rate setting behavior.

Taylor Rule Exchange Rate Forecasting during the Financial Crisis

Taylor Rule Exchange Rate Forecasting during the Financial Crisis

ANALYSIS OF THE ECB MONETARY POLICY MATCH FOR THE NEEDS OF THE EURO AREA COUNTRIES NEEDS

Abstract. In this paper, using the Taylor rule (Taylor, 1993), the European Central Bank (ECB) monetary policy in 2000–2012, as well as individual interest rate needs of the euro area (EA) countries are analysed. It is assumed that the estimated Taylor rule interest rates are optimal for individual members. We have analysed whether the actual ECB interest rates and the calculated rates are different and have become more balanced towards individual countries’ needs. The work focuses attention on the last period (2008–2012) when the EA faced economic problems and an asymmetric shock. The analysis shows controversial results: on the one hand, the interest deviation mean decreases (just a little), but an increasing gap between individual needs can be seen: some countries are becoming increasingly divorced from the general EA needs. It makes them very vulnerable, and there is a risk that these countries in the face of asymmetric challenges can be “left behind” by the ECB focusing on the EA as a whole. Also, in this paper, the stationarity of the calculated deviations is analysed to help understand their nature. This approach is new, and the author is unaware of similar works. Analysis of the optimal interest rate dynamics has revealed that Germany needed the interest rates that were opposite to the needs of Spain and Greece and susceptible to divergence, so this led to the ECB difficulties in determining the proper interest for all countries’ needs. The EA as a currency area is most optimal for Belgium, Cyprus, Finland, France, Italy, and the Netherlands from the interest rate setting perspective.Key words: the Taylor rule, optimal monetary policy, asymmetric shocks, optimal currency area