Modified Taylor Rule Research Articles

Milton Friedman and nominal income targeting

AbstractFor much of his career, Milton Friedman advocated a constant monetary growth rule to limit central bank discretion and to achieve long‐term price stability. By contrast, Friedman wrote little on nominal income stabilization as an alternative goal for monetary policy. Nevertheless, a careful examination of Friedman's work shows that in his view the desirability of a constant monetary growth rule depended on its ability to stabilize nominal income. Friedman's preference for simple rules, requiring minimal knowledge on the part of central banks, would have given him strong reason to support nominal income targeting over central banks' standard practice of inflation targeting. Several strategies for achieving a nominal income target are considered, including a modified Taylor rule and several monetary base rules.

Os comentários políticos comandam? O caso do Banco Central do Brasil

ABSTRACT This paper investigates whether political pressure affects the conduct of monetary policy in Brazil. For the period between January 2010 and August 2020, we estimate a modified Taylor rule to empirically test whether the calls for lower interest rates by presidents induce Central Bank of Brazil (BCB) to lower the policy rate. We document that BCB is more likely to set the policy rate in line with the preferences of political leaders. We also show that the response of BCB to political pressure remained significant even though political pressure diminished in recent years.

Applying Taylor Rule in a Heterogeneous Currency Union: Case of UMAC

Our objective is to show that the Taylor rule is the monetary policy practice of BEAC its effectiveness is limited due to the structural and cultural heterogeneity of the currency union. In this light, we identify the reaction function of BEAC show that it includes additional variables namly, the interest rate and inflation differential with the Euro zone, as well as the currency reserve ratio that must cover at least 20% monetary issue. Given the objectives and instruments used and the reaction function built, we estimate a forward-looking Taylor rule using the GMM, similar to the one proposed by Clarida et al. (2000) and find that the interest rate setting of BEAC could be captured using a Taylor rule. From our estimations using the we actually find that BEAC’s monetary policy or more precisely its interest rate setting can be effectively captured using a modified Taylor rule taking into consideration the specificities of the monetary union and external constraint despite the heterogeneous nature of the union. As seen from the results obtained we can realize that the Central Bank mainly focuses on the fight against inflation and mainly strives at maintaining internal stability in the sub region. This fight can be deemed successful given the low inflation results that are observed in our period of study, even though it can be mitigated with the influence of the region of anchor (the Euro zone) in this stability

Monetary and Fiscal Policy in Times of Crises: A New Keynesian Perspective in Continuous Time

To analyse the interdependence between monetary and fiscal policy during a financial crisis, we develop an open-economy DSGE model with monetary and fiscal policy as well as financial markets in a continuous-time framework based on stochastic differential equations. Monetary policy is modelled using both a standard and a modified Taylor rule and fiscal policy is modelled as either expansionary or austere. In addition, we differentiate between open economies and monetary union members. We find evidence that the modified Taylor rule notably reduces the likelihood that the financial market crisis affects the real economy. But if we assume that households are averse with respect to outstanding government debt, we find that a combination of expansionary monetary policy and austere fiscal policy provides better stabilisation of both domestic and foreign economies in terms of both output and inflation. In the case of a monetary union, we find that stabilisation of output in the country where the financial shock originates is no longer as easy and, in terms of prices, there is now deflation in the country where the crisis originated and a positive inflation rate in the other country.

Normalizing the Central Bank's Balance Sheet: Implications for Inflation and Debt Dynamics

AbstractWe explore the effects of reducing the overall size of the central bank's balance sheet and lowering its maturity structure. To do so, we consider an environment where fiscal policy is traditionally passive and the central bank follows the Taylor principle. In addition, the monetary authority has also explicit size and compositional rules regarding its balance sheet. Agents in this economy face limited commitment in some markets and government bonds can be used as collateral. When short‐ and long‐term public debt exhibit premia, changes in the central bank's balance sheet have implications for long‐run inflation and real allocations. To ensure a unique locally stable steady state, the central bank should target a low enough maturity composition of its balance sheet. In our numerical exercise, calibrated to the United States, we find that long‐term debt holdings by the central bank should be less than 0.5 times of their short‐term positions. Moreover, the process of balance sheet normalization should aggressively respond to the total debt issued in the economy relative to its target. These findings depend on the degree of liquidity of long‐term bonds. The more liquid long‐term bonds are, the lower is the value of the composition threshold and the parameter space consistent with unique and stable equilibria is smaller. In addition, we consider a modified Taylor rule that takes into account the premium. Such a rule increases the prevalence of multiplicity of steady states and delivers lower welfare. Thus, we argue that the traditional Taylor rule is appropriate for managing interest rates in the presence of premia.

External debt management as macroprudential policy in a small open economy

This paper examines the role of macroprudential policy and foreign exchange rate intervention in stabilizing the economy facing foreign shocks. To this end, we build a small open economy dynamic stochastic general equilibrium (DSGE) model with a banking sector. We add foreign loans by entrepreneurs regulated by a macroprudential policy via a foreign to domestic loan ratio requirement. The exchange rate intervention is undertaken via a modified Taylor rule. From the analysis, two important results emerge. First, the responses of aggregate output, consumption, investment, and inflation vary widely for different types of foreign shock and policy combinations. Second, the stabilization gain seems to depend on the type of foreign shock hitting the economy. When the economy is hit by a foreign interest rate shock, tightening the macroprudential measure reduces the volatility of output, consumption, and investment-more than if the stabilization effort is carried out through an exchange rate intervention. However, under a risk premium shock, this gain diminishes substantially.

The golden rule of public finance under active monetary stance: endogenous setting for a developing economy

The paper aims to verify the introduction of the golden rule of public finance under an active monetary stance for a developing economy using a dynamic stochastic general equilibrium model. Besides the two rigidities, namely the deep habit formation and Calvo-style price stickiness, the model structure incorporates real money holdings and welfare-enhancing government purchases in the utility-generating function and a modified Taylor rule. The simulation results have validated the visible crowding-out of private consumption and investment in the short run and a positive impact of the productive government spending on long-run growth, but with some important caveats. In the case of a developing economy that usually has low efficiency and high returns to public capital, the given factors prove significant in addressing the study issue. The results are robust in terms of the structure of utility-generating function, a relatively high share of liquidity-constrained households, and a degree of price stickiness. Moreover, to offset the debt accumulation as a result of increased public investment financing by persistent output growth, in the long run, the central bank should not only rely on response to the fluctuation of inflation and output but also account for a move of public debt.

Is the Taylor rule optimal? Evaluation using a wavelet-based control model

ABSTRACT This paper extends the wavelet-based control (WBC) model of Crowley and Hudgins (2015) to compare the simulated performance of jointly optimal fiscal and monetary policy, where the policymakers place emphasis on a variety of macroeconomic targets, with the case where monetary policy follows a modified Taylor rule. The results show that the Taylor rule is likely to render higher interest rates, diminished investment, and appreciated real exchange rates compared with an unconstrained baseline simulation. We therefore find that the Taylor rule is suboptimal since it results in higher fiscal deficits due to substitution by policy authorities, thus confirming recent research on the interaction of fiscal and monetary policies. The analysis also compares the baseline and Taylor rule simulated forecasts when the central bank adopts a ‘hawkish’ inflation policy compared to a more ‘dovish’ policy stance.

CENTRAL BANKS' RESPONSE TO INFLATION, OUTPUT GAP, AND EXCHANGE RATE IN NIGERIA AND SOUTH AFRICA

This study examines inflation targeting in Nigeria and South Africa, using fully modified least square to estimate a modified Taylor rule for the period 1970 to 2016. The study unravels evidence of a significant response of inflation and squared inflation to policy interest rates in South Africa, but not in Nigeria. Overall, South Africa�s central bank places much emphasis on inflation targeting in setting interest rates which Nigeria does not. Further, for South Africa, output gap is significant, while it is not significant for Nigeria. The study also reveals that exchange rate, openness to trade and international reserves play significant roles in central bank policy in both countries. In other words, there is need for central banks to adopt an eclectic approach, setting the monetary policy rule to adjust to any observed disequilibrium between output gap, inflation, exchange rate, foreign reserves and openness to trade. However, strict inflation targeting may not serve as an appropriate framework to address the crucial macroeconomic problems challenging these African economies. However, developing countries� central banks, such as in Nigeria and South Africa, often have weak financial, fiscal and monetary institutions, thus rendering the application of inflation targeting considerably difficult. In this regard, the degree of the triumph of inflation targeting significantly depends on executive capacity, and the political will and commitment on the part of the central banks. The central banks should therefore be flexible about inflation objectives/targets when confronted with more pressing macroeconomic problems that could be remedied using existing policy instruments. From the findings of this study, it can be seen that there is a need to adopt an eclectic approach to setting the monetary policy rule. It is important to set the interest rate to adjust to any observed disequilibrium between output gap, inflation, exchange rate, foreign reserves and openness to trade. In fact, strict inflation targeting may not be an appropriate framework to solve the key macroeconomic problems challenging these African economies, such as price instability, exchange rate stability and inclusive economic growth. Still, inflation targeting remains a relevant policy approach but may not be adequate in its capacity to deal with economic and financial crisis if deployed only.

Měnová politika - kudy dál?

Various theoretical perspectives on the current macroeconomic development of advanced economies, indicating a slowdown in economic growth and labour productivity accompanied by very low inflation, are discussed. Mainstream opinion has been emphasizing the threat of se-cular stagnation, which would require much looser monetary policy compared to past decades. On the other hand, opinions pointing to the limits and risks of a long-term loose monetary policy are analysed. Special attention is paid to the phenomenon of deflation. Biases of measurement of basic macroeconomic indicators in the age of digitization are discussed as well. As a possible way forward in monetary policy, incorporation of labour market indicators seems to be promising. In the age of digitization, labour market statistics are more reliable than indicators of output and/or inflation. An experimental example of a modified Taylor rule for the Czech economy provides supportive arguments for using available indica tors from the labour market in the process of monetary policy decision making to a greater extent compared to current practice.

Actual interest rates versus hypothetical interest ratesresulting from the Taylor rulein the euro area and the United States

The aim of the article is to examine the degree of matching actual interest rates with hypothetical ones, calculated on the basis of original and modified (with greater GDP gap significance when setting interest rates) Taylor rule. The analysis was conducted for the two largest world economies by nominal GDP, i.e. the euro area and the United States of America for the period 2001—2017.Two hypotheses were tested in the article. Firstly, the actual interest rates of the Europe-an Central Bank are more strongly correlated with the rates resulting from the original Taylor rule. Secondly, the actual interest rates of the Federal Reserve System are more strongly correlated with the rates arising from the modified Taylor rule. On the basis of the conducted analysis, the first hypothesis was confirmed, while the second one was rejected.However, it should be noted that the results of the study could be different were it not for the economic crisis, macroeconomic destabilization and lack of the possibility of reducing interest rates related to zero lower bound. That particularly applies to the second hypothesis and the 2008—2017 sub-period.

Exchange Rate Pass-through, Nominal Wage Rigidities, and Monetary Policy in a Small Open Economy

Exchange Rate Pass-through, Nominal Wage Rigidities, and Monetary Policy in a Small Open Economy-Incomplete Pass-through, Nominal Wage Rigidities, Modified Taylor Rule, Monetary Policy, Small Open Economy

Labor market friction, nominal wage rigidities, and monetary policy in a small open economy

We incorporate some of the essential ingredients and properties of search and matching model of unemployment into a New Keynesian small open economy and study their implications for monetary policy. Three simple interest rate rules (strict Inflation Targeting, standard Taylor rule, and a modified Taylor rule) are studied. The message conveyed from this study can be viewed as twofold. First, conditional on the domestic productivity shock, a standard Taylor rule is welfare enhancing. Conditional on the foreign income shock, however, welfare losses is minimized under the strict inflation targeting rule. Second, the modified Taylor rules that respond to unemployment rate rather than output is second-best for both domestic technology and foreign income shocks. Therefore, it can be argued that stabilizing unemployment rate rather than output could be the better if policy-maker is uncertain about the types of shocks.

Reassessing Taylor rules using improved housing rent data

There is a debate whether the federal funds rate deviated from the Taylor rule. We present evidence that standard inflation measures do not reflect the contemporaneous state of housing rents, which are a large part of price indexes. Using a new housing rent index (RRI) developed by Ambrose et al. (2015), we compute the RRI-based Taylor rule for the period from 2000 to 2010. The modified Taylor rule indicates that seemingly large deviations are better understood as delays due to the stale information regarding housing rents. It also provides a justification for Quantitative Easing and a better alternative to other versions of Taylor rules.

EFFECT OF INFLATION TARGETING POLICY ON U.S. TRADE IMBALANCE

ABSTRACT This paper investigates the relationship between inflation targeting policy and U.S. trade imbalance. This study uses a simple DSGE approximation under three inflation targeting scenarios based on a modified Taylor rule which includes foreign interest rate but excludes output gap. The driving forces are rational expectations components of consumption Euler equation, and inflation rate. Other variables used include domestic and foreign interest rates, exchange rate, exports, imports, and capital inflows. Optimal parameter estimates based on 1980 to 2014 quarterly data indicate that inflation targeting has a destabilizing force on the change in trade imbalance. The magnitude of targeted rate whether1percent or 2 percent is not a significant factor in altering changes in trade imbalance. Accuracy of this approximation is verified by the Judd-Gaspar test on inflation rate. Chow test result confirms the significance of the 2008 Great Recession on a structural change in the U.S. economy. Keywords Inflation targeting, U.S. trade imbalance, DSGE approximation

Modern features of a monetary policy of the BRICS countries: An empirical analysis and modeling results of a modified Taylor rule

Modern features of a monetary policy of the BRICS countries: An empirical analysis and modeling results of a modified Taylor rule

Monetary and Fiscal Policy in Times of Crisis: A New Keynesian Perspective in Continuous Time

To analyse the interdependence between monetary and fiscal policy during a financial crisis, we develop an open‐economy DSGE model with monetary and fiscal policy, as well as financial markets, in a continuous‐time framework based on stochastic differential equations. Monetary policy is modelled using both a standard and a modified Taylor rule and fiscal policy is modelled as either expansionary or austere. In addition, we differentiate between open economies and monetary union members. We find evidence that the modified Taylor rule notably reduces the likelihood that the financial market crisis affects the real economy. However, if we assume that households are averse to outstanding government debt, we find that a combination of expansionary monetary policy and austerity‐oriented fiscal policy does a better job of stabilising both domestic and foreign economies in regard to both output and inflation. In the case of a monetary union, we find that stabilization of output in the country where the financial shock originated is no longer as easy and, in terms of prices, there is now deflation in that country and a positive inflation rate in the other member country of the monetary union.

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.

Taylor rule deviations and out-of-sample exchange rate predictability

The Taylor rule has become the dominant model for academic evaluation of out-of-sample exchange rate predictability. Two versions of the Taylor rule model are the Taylor rule fundamentals model, where the variables that enter the Taylor rule are used to forecast exchange rate changes, and the Taylor rule differentials model, where a Taylor rule with postulated coefficients is used in the forecasting regression. We use data from 1973 to 2014 to evaluate short-run out-of-sample predictability for eight exchange rates vis-à-vis the U.S. dollar, and find strong evidence in favor of the Taylor rule fundamentals model alternative against the random walk null. The evidence of predictability is weaker with the Taylor rule differentials model, and still weaker with the traditional interest rate differential, purchasing power parity, and monetary models. The evidence of predictability for the fundamentals model is not related to deviations from the original Taylor rule for the U.S., but is related to deviations from a modified Taylor rule for the U.S. with a higher coefficient on the output gap. The evidence of predictability is also unrelated to deviations from Taylor rules for the foreign countries and adherence to the Taylor principle for the U.S.

MONETARY POLICY AND DEBT DEFLATION: SOME COMPUTATIONAL EXPERIMENTS

The paper presents an agent-based model to study the possible effects of different fiscal and monetary policies in the context of debt deflation. We introduce a modified Taylor rule that includes the financial position of firms as a target. Monte Carlo simulations provide a representation of the complex feedback effects generated by the interaction among the different transmission channels of monetary policy. The model also reproduces the evidence of low inflation during stock market booms and shows how it can lead to overinvestment and destabilize the system. The paper also investigates the possible reasons behind this stylized fact by testing different behavioral rules for the central bank. We find that, in a context of sticky prices and volatile expectations, endogenous credit creation can be identified as the main source of the divergent dynamics of prices in the real and financial sectors.