Taylor Rule Research Articles

Divergent Relationships between Exchange Rate Pass-through and Policy Rates Across Economies: An Extension of the Taylor Rule

Although central banks often prioritize exchange rate stability, its role is frequently overlooked in the monetary policy analysis and simple interest rate rules do not comprise exchange rate arguments even in small open economies. This study extends the traditional Taylor rule by incorporating exchange rate deviations to determine their influence on monetary policy conduct across various economies. Our findings reveal heterogeneous impacts of exchange rate deviations on policy rates. Specifically, exchange rates significantly influence monetary policy in economies with fixed exchange rate regimes, higher foreign reserve ratios and lower levels of financial development.

Leaning against the wind in the New Keynesian model with heterogeneous expectations

In this paper, we explore the efficiency of the Leaning Against the Wind (LAW) policy within the New Keynesian framework with heterogeneous expectations. To do this, we add a financial sector to the model, linking it with the real sector via the financial accelerator channel. We find that the range of parameters in the Taylor rule that enable the stability of the targeted equilibrium is reduced with the financial accelerator. However, expanding the Taylor rule via the LAW policy fails to counteract this effect and may even exacerbate it if the policy reacts to any mispricing. If applied conditionally on high mispricing, the LAW policy leads to co-existing stable targeted and non-targeted equilibria. Our simulations suggest that while the LAW policy can reduce the amplitude of endogenous fluctuations, it is inefficient in dealing with exogenous shocks and results in larger average deviations from the target.

Monetary policy and sentiment-driven fluctuations

Sentiments, or beliefs about aggregate demand, can be self-fulfilling in models departing slightly from the complete information benchmark in the New Keynesian framework. Through its effect on aggregate variables, the policy stance determines the degree of complementarity in firms' production (pricing) decisions and consequently, the precision of endogenous signals that firms receive. As a result, aggregate fluctuations can be driven by both fundamental and non-fundamental shocks. The distribution of non-fundamental shocks is endogenous to policy, introducing a novel tradeoff between stabilizing output and inflation. Both strong inflation targeting and nominal flexibilities increase the variance of non-fundamental shocks, which are shown to be suboptimal. Moreover, the Taylor principle is no longer sufficient to rule out indeterminacy. Instead, an interest rate rule that places sufficiently low weight on inflation eliminates non-fundamental volatility and thereby the output-inflation tradeoff.

Conventional vs. unconventional monetary policy under credit regulation

Abstract We provide empirical evidence that the impact of quantitative easing (QE) programs on investment is weaker for countries with high-credit market regulations. We then extend a simple DSGE model with segmented financial markets to include credit regulation and examine its impact on the transmission of conventional and unconventional monetary policies. In our model, the government requires banks to hold a fraction of their assets in government debt. We show that the presence of such regulation can invert monetary transmission under QE policy: An expansionary QE program raises term premiums on corporate bonds and causes a contraction instead of an expansion in the economy. Such a perversion is absent under conventional policy. Further, in contrast to Carlstrom et al. (2017), we show that a simple Taylor rule welfare dominates a term premium peg under financial shocks, while the peg does better in the case of non-financial shocks.

Exchange Rate Pass-Through on Prices in Nigeria—A Threshold Analysis

Persistent exchange rate depreciation and its debilitating effects on rising inflation have remained a concern in Nigeria. This article explores the effects of exchange rate pass-through on producer prices, consumer prices, export prices, import prices and the Taylor rule from 2000 to 2023, using quarterly data and adopting threshold autoregression and self-exciting smooth threshold regression methods. The findings suggest that there are non-linearities in the way that exchange rate depreciation affects prices in Nigeria. Furthermore, the findings suggest a threshold of 5 percent depreciation. Two sub-sample analyses corroborate the main findings, showing that a threshold of 5 percent is the optimum benchmark if demand and supply are not to be weakened. At this level or below, the effects of exchange rate depreciation on inflation are much lower, even though prices will rise. However, above this benchmark, the effects of depreciation on inflation are much larger, weakening consumer demand for both imported and domestic goods as well as producer supply of both exported and domestic goods and services in the economy. This result implies that an average exchange rate depreciation not higher than 5 percent within a quarter is reasonable if the Nigerian economy is to remain competitive both domestically and globally. Finally, the results suggest that the exchange rate pass-through to prices is considerably higher in Nigeria below the threshold, while it overshoots for producer prices, export prices, and import prices above the threshold. To keep inflation in check, this paper suggests that the monetary authorities should try to keep exchange rate depreciation below the established thresholds, while also considering adjusting the policy rate to take into account the exchange rate depreciation thresholds in order to keep domestic prices stable.

The influence of unconventional monetary policy tools: an euro area perspective

Purpose – This article aims to investigate the influence of unconventional monetary policy tools (UMPTs) employed by the European Central Bank (ECB) on the inflation rate and GDP growth rate within the euro area, motivated by the principles of the Taylor rule. Research methodology – Elastic net regression with ARIMA residuals was used to analyse the relationship between UMPTs and economic indicators, measured by adjusted R-squared. Six samples were constructed, and hypothesis testing was performed using moving block bootstrapping. Residual diagnostics were used for model validation. Findings – The study revealed significant impacts of UMPTs, particularly in combination with interest rates, on inflation rates. However, adjusted R-square values for GDP growth rate were less pronounced, indicating a more complex relationship. Research contributes to understanding the dynamics of monetary policy transmission mechanisms, informing policy institutions, and guiding future research directions. Research limitations – Limitations include the focus on the euro area and the absence of analysis in other major economies. Future research should address these limitations and incorporate additional variables for a more comprehensive analysis. Practical implications – The findings provide insight for policymakers regarding the efficacy of UMPTs in influencing inflation rates, aiding in informed decision-making in monetary policy formulation and implementation. Originality/Value – This study contributes novelty by comprehensively analysing the relationship between UMPTs and economic indicators within the euro area, providing valuable insight into monetary policy institutions, and guiding future research directions.

Nominal GDP growth targeting vs. Taylor rules in a model with financial frictions

Nominal GDP growth targeting has gained favor over the last few decades in monetary policy literature (e.g., Ireland 2020; Garín et al. 2016; Beckworth and Hendrickson 2020). Calibrated, small-scale New Keynesian DSGE models have supported the proposition that nominal GDP growth (NGDP growth) rate targeting will improve welfare as compared with alternative strategies such as inflation targeting and Taylor rules with standard parameter settings. This paper examines that proposition in the context of a medium-scale New Keynesian model having a financial sector with frictions. In that model, NGDP growth rate targeting does poorly as compared with the Optimal Taylor rule and a wide range of Taylor rule settings leading up to the Optimal (representative agent utility maximizing) Taylor rule. The presence of the financial sector reveals that not only is NGDP growth rate targeting the least successful among the alternative targets and rules in creating welfare in this model; NGDP growth rate targeting also creates dramatically higher volatility of the policy rate and most financial variables.

Macroeconomic and political determinants of the brazilian basic interest rate

This paper aims to investigate the formation of benchmark interest rates by understanding the factors that may influence the target set by the Brazilian Monetary Council for the Selic rate. To achieve this, data from 2003 to 2024 are analyzed to estimate a Taylor rule for Brazil through an autoregressive distributed lag (ARDL) model. The results suggest that the management of Brazilian monetary policy adheres to the principles of the Taylor rule and has been influenced by structural changes. Extreme events, such as the Subprime crisis and COVID-19, may have impacted the decisions of the monetary authority, while the 2016 impeachment and different presidential administrations did not show statistically significant effects. These findings contribute to the scientific literature on interest rate formation by providing empirical evidence for Brazil and offer valuable insights for policymakers and other economic agents who consider monetary policy in their decision-making processes.

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.

Exchange rate and inflation dynamics in Kenya: Does the threshold level matter?

This study empirically examined the threshold effect of exchange rate pass-through (ERPT) on inflation in Kenya, while augmenting the exchange rate depreciation in the monetary policy rate using the Taylor rule. The monthly time series data spanning January 2005 to November 2023 was collected for analysis, in which the non-linear threshold autoregressive (TAR) model was employed as the main econometric model. This study's ERPT results reveal that, exchange rate depreciation has positive and significant effect on inflation only when it raises above the monthly threshold level of 0.51 %. In contrast, the Taylor rule analysis results reveal that the exchange rate depreciation has a positive and significant effect the monetary policy rate regardless of the threshold level of 0.67 %. Therefore, keeping domestic currency depreciation below a monthly growth rate of 0.51 % will control the pass-through effect on inflation, and the exchange rate depreciation at any level should always act as a reaction function for the monetary policy rate setting. This study also found that the relationship between exchange rate depreciation and inflation, as well as monetary policy rate is non-linear, which implies a greater pass-through effect when exchange rate depreciation is high. Therefore, we recommend the monetary authority in Kenya to pay attention to the depreciation of the exchange rate depreciation at any level when adjusting the policy rate to tame inflation.

Inflation targeting, output stabilization, and real indeterminacy in monetary models with an interest rate rule

AbstractCentral banks set the nominal interest rate to target inflation and stabilize output. In monetary models, monetary policy affects output directly via the wealth effect. I show that in these models, the response of the central bank to fluctuations in output may induce real indeterminacy even if the Taylor principle is satisfied. I find that the determinacy conditions depend on the interest elasticity of output and generally, the Taylor principle is neither necessary nor sufficient for determinacy. This is in stark contrast with the New Keynesian model where a sufficiently strong policy response to inflation or output usually ensures determinacy.

Taylor rules during a pandemic: a counterfactual exercise

ABSTRACT We conduct a counterfactual exercise to determine the potential effectiveness of conventional monetary policy to limit the economic damage caused by labour market uncertainties related to a pandemic. We model the labour market uncertainty as a second-order shock to a time-varying job separation rate. We show that the economic effects of heightened uncertainty in the job separation rate depend crucially on the Taylor-rule type adopted by the monetary authority. We explore the quantitative implications of pandemic-induced job separation uncertainty shocks under alternative interest rate rules and find that recessions following job separation uncertainty shocks are more severe under rules with no interest rate smoothing and strong inflation targeting.

How to get monetary policy back on track

The presentation is based on research which focusses on the actions of the Federal Reserve and on other central banks around the world. The message of the presentation is that the Federal Reserve had got behind the curve—based on the widely quoted Taylor Rule. Now they have raised the federal funds rate, and they are much less behind the curve. The question now is how they and other central banks—including the European Central Bank and the Bank of Japan—will get back on track. That is the aim of the paper.

Trend inflation and exchange rate dynamics: A new Keynesian approach

This study examines the exchange rate implications of trend inflation within a two-country New Keynesian (NK) model. An NK Phillips curve generalized by trend inflation makes the inflation differential smoother, more persistent, and less sensitive to the real exchange rate. A Bayesian analysis with post-Bretton Woods data for Canada and the U.S. shows that the model's equilibrium, which relies on Taylor rules with a persistent trend inflation shock and strong policy inertia, mimics empirical regularities in exchange rates that are difficult to reconcile within a standard NK model. Trend inflation helps explain the empirical puzzles of the exchange rate dynamics.

International interest rate comovements and monetary policy in Bazil

This article shows that international spillovers or coordination in central bank interest rate setting are significant components of the Brazilian Taylor rule. For this, the short-term interest rate comovements of 28 countries and Euribor were estimated through a dynamic factor model. A nonlinear reaction function for the Central Bank of Brazil that includes global and regional factors evidenced that monetary policy in Brazil is influenced by the policy of other broad groups of countries and not just the United States and the Eurozone.

Monetary Policy and Heterogeneity: An Analytical Framework

Abstract THANK is a tractable heterogeneous-agent New-Keynesian model that captures analytically core micro-heterogeneity channels of quantitative-HANK: cyclical inequality and risk; self-insurance, precautionary saving, and realistic intertemporal marginal propensities to consume. I use it to elucidate key transmission mechanisms and dynamic properties of HANK models. Countercyclical inequality yields aggregate-demand amplification and makes determinacy with Taylor rules more stringent; but solving the forward guidance puzzle requires procyclical inequality: a Catch-22. Solutions include combining inequality with a distinct risk channel, with compensating cyclicalities; I provide evidence that disposable income inequality was procyclical in the last two, Great and COVID recessions, while risk is countercyclical. Alternative policy rules also solve the Catch-22, e.g. price-level-targeting or, in the model version with liquidity, setting nominal public debt. Optimal policy with heterogeneity features a novel inequality-stabilization motive generating higher inflation volatility—but is unaffected by risk, insofar as the target efficient equilibrium entails no inequality.

Old-Keynesianism in the New Keynesian Model

I investigate an ‘old Keynesian’ fiscal policy in which government spending endogenously responds to inflation and the output gap when the nominal interest rate is pegged at the ZLB. I do so within a standard Representative Agent New Keynesian model (RANK), as well as a two-period Overlapping Generations New Keynesian model (OLG-NK). For both model versions, I find that the equilibrium values for inflation and the output gap under a standard Taylor rule regime can be replicated under the ‘old Keynesian’ regime. However, a unique stable countercyclical equilibrium is only feasible within the OLG-NK model and crucially depends on the pension system.

CAN EXCHANGE RATE CONTROL IN TURKEY HELP THE CENTRAL BANK EVALUATIONS WITHIN THE FRAMEWORK OF THE TAYLOR RULE

This paper tests the validity of the Augmented Taylor rule in the Turkish economy for the period between February 2011 and February 2024 with the structural vector autoregression model. It is found that the central bank did not use the policy rate against deviations from inflation in the relevant period. On the other hand, the policy rate moves within expectations against deviations in the output gap and the real exchange rate. According to the structural impulse-response functions, the output gap and the inflation gap respond positively to a one-unit shock to the policy rate, while the real exchange rate reacts negatively. According to the results of structural variance decomposition, the most influential variable on changes in the policy rate is the real exchange rate deficit. In conclusion, the policy rate in the Turkish economy takes into account the output gap and the real exchange rate gap. However, it ignores the inflation gap.

Should Monetary Policy in South Africa Lean against the Wind by Targeting the Financial Cycle?

Recently, several studies have argued about the interactions of the real economy and financial system, as well as the importance of financial cycles in business cycle fluctuations. To date, there exists near consensus among central bankers, economists, and other scholars that the financial cycle is an important source of business cycle fluctuations. This has raised the question of whether monetary policy should respond to financial instability and/or imbalances. As a result, we asked the following questions: Should monetary policy lean against the wind by targeting the aggregate financial cycle in South Africa? And what is the role of monetary policy in minimizing financial imbalances and instabilities in South Africa? The present article aims to provide answers to the above-mentioned question. Through the adoption of a multiple-equation generalized method of moments and structural vector autoregressive approaches, this article simultaneously estimates and compares both the finance-augmented and the conventional Taylor rules. It is shown that the South African Reserve Bank has considered developments in the aggregate financial cycle in setting its policy rate. Overall, there is clear evidence to conclude that the South African Reserve Bank can lean against the wind by targeting the aggregate financial cycle, but only as a genuine augmentation not as a fully flagged objective. This article adds new evidence to the South African literature on the prevailing debate of whether monetary policy should respond to developments in the financial system.

General Equilibrium Model for Monetary Policy Responses to Macroeconomic Instabilities in Developing Economy: A Ghanaian Perspective

The study develops a standard New Keynesian model to examine how monetary authority reacts to both domestic and external shocks as well as how its policy decision impacts the general macroeconomy in developing African economy. Using Bayesian estimation techniques and a Ghanaian dataset, the article also seeks to determine the best-suited monetary policy rule for Ghana and countries with similar characteristics. The basic finding is that a forward-looking Taylor rule—where authority reacts to one-period-ahead inflation deviation from target alongside the current output gap—is the most appropriate monetary policy rule for Ghana. Another salient finding is that variations in output are mainly driven by price markup, labour supply, monetary policy and productivity shocks across the forecast horizons. In addition, the dominant determinants of inflation are exchange rate risk premium and price markup shocks. Collectively, the article also unveils that monetary policy responses to macroeconomic shocks are broadly in line with conventional economic theory. There is also conspicuous evidence that the general equilibrium model with representative consumers is practically suitable for monetary policy analysis in Ghana, as contractionary monetary policy impulse is able to contemporaneously induce disinflation and output contraction. Given the strong evidence of a large segment of the unbanked population in Ghana, the findings in this study could be verified based on a model that allows for the co-existence of optimizing and non-optimizing consumers. JEL Classification: B41, C5, C11, D11, D21, D41, D42, E2, E12, E43, E52, E58, F31, F41