Taylor Rule Research Articles

"Monetary policy measures and strategies in the context of the adoption of the euro currency "

"The importance of knowing the effects resulting from the adoption and implementation of monetary policy decisions on economic variables is a decisive factor of this article, which directed our attention to the issue of monetary policy measures. Taking into account the thematic area, this concept falls, without exception, in the field of the monetary economy, so it allows the author to carry out a rigorous, complex analysis supported by notions found in the field of finance, economic-financial integration, international relations, as well as macroeconomics. Identifying the behavior of central banks in establishing monetary policy strategies constitutes the fundamental objective of the paper and can provide a conclusive and appropriate picture of both the objectives considered and their prioritization. A standard approach in this context is to estimate a central bank reaction function in the form of a Taylor rule. By using the previously mentioned method, the identification of the final objectives of the monetary policy authorities through the lens of the promoted policy is considered. The analysis will focus on states such as Romania, Hungary, Poland, and the Czech Republic, all committed to adopting a single currency according to the Treaty on the Functioning of the European Union. The present analysis has brought to the fore the monetary policy measures and strategies used mainly by Central and Eastern European central banks. "

Business Cycles and Monetary Policy Analysis in a Structural Sticky Price Model of the Lebanese Economy

A medium-size structural model is built in this article in order to define and reshape the Lebanese economy characteristics and features. However, the structural model is featured by a Taylor monetary policy rule design with nominal interest smoothing. Including the Taylor rule helped us to analyze the response function of each variables to different monetary policy shocks. Hence, the results of this paper showed how changing coefficients may influence the standard deviations of variables in the model as such the inflation rate, the nominal interest rate and the output GAP. More precisely, the performance of the model is detected while moving the coefficients assuming that monetary authorities’ intention is to reduce volatility in the three mentioned variables. Consequently, our findings proved that the coefficient of responsiveness to inflation deviations, the output GAP coefficient and the nominal interest rate coefficient are little bit larger than the ones reported in empirical works for the Euro area1. Therefore, these results reflect in some way that the Lebanese Central bank conduct its monetary policy with some responsiveness, in addition, findings ensure that actual behavior of the Lebanese central bank regarding the nominal interest rate setting is well captured by a Taylor rule including the initial proposed coefficients.

Bank credit, inflation, and default risks over an infinite horizon

The financial intermediation wedge of the banking sector used to co-move positively with the federal funds rate, but the post-GFC era saw a disconnect between them. We develop a flexible price dynamic general equilibrium with banks’ liquidity creation to offer an explanation. In a corridor system, the financial wedge and policy rate are shown to co-move, and the pass-through of monetary policy onto both inflation and output obtains. However, the post-GFC floor system obviates the need for the financial wedge to cover the cost of obtaining reserves, so the wedge and the policy rate indeed disconnect in equilibrium; furthermore, we show that the disconnect obstructs monetary expansions from generating inflation. In this environment, tightening bank capital requirement leads to disinflationary pressure. Money-financed fiscal expansions that subsidise non-bank sectors’ borrowing costs improve output and reduce default risks but increase inflation. The model uses banks’ liquidity creation via credit extension to provide a rationale for both the pre-pandemic disinflation and the post-pandemic inflation. The results hold both on the dynamic paths and in the steady state, and the role of money enlarges the Taylor rule determinacy region.

Some Unconventional Properties of New Keynesian DSGE Models

We examine the theoretical and numerical properties of a prototypical New Keynesian DSGE model featuring endogenous capital accumulation and labour supply. We find that this completely conventional model yields implausible impact results following unanticipated and temporary shocks when the monetary closure rule is changed from a policy rule setting nominal interest rates (a Taylor Rule) to a fixed money supply rule. We compare and contrast a variety of New Keynesian models, featuring aggregate price stickiness, with their New Classical counterparts featuring perfectly flexible prices. In line with the literature we find that under a Taylor Rule the impulse-response functions following a technology shock are very similar. In contrast, with a fixed money supply the impact effects for the New Keynesian model are implausible. We demonstrate the robustness of this Implausible Result to alternative parameter values and show that it is ultimately caused by the inflexibility of the capital stock relative to that of the real money supply. We suggest several model extensions which will eliminate the Implausible Result from New Keynesian sticky-price models.

Modeling which Factors Impact Interest Rates

Abstract The Taylor (1993) rule for determining interest rates is generalized to account for three additional variables: The money supply, money velocity, and the unemployment rate. Thus, five parameters, i.e. weights assigned to the deviation in the inflation rate, the deviation in real GDP (Gross Domestic Product), the deviation in money supply, the deviation in the money velocity, and the deviation in unemployment rate, are introduced and estimated. The article explores and tests various combinations of the Taylor rule, the Quantity Equation (Friedman, 1970), and the Phillips (1958) curve. The monthly US January 1, 1959 to March 31, 2022 data are adopted to test the optimal parameter values. Estimating the parameters with the least squares method gives better results than the Taylor rule. The optimal parameter values involve a relatively high weight to the deviation in unemployment rate, and moderate weights are assigned to the deviation in the inflation rate, the deviation in real GDP, the deviation in money supply, and the deviation in the money velocity. The corresponding sum of squares decreases by 42.95% when compared with the Taylor rule.

A Brief Review of New Neoclassical Synthesis of Monetary Policy

This article reviews the central tenants of the New Neoclassical Synthesis of monetary policy. Starting with the optimising behaviour of central banks, this article reviews different theoretical developments like the role of expectations, the Taylor Principle, time-inconsistency, central bank independence and the importance of financial markets for monetary policy. The article concludes by highlighting the challenges faced by policymakers.

Wealth in utility, the Taylor principle and determinacy

Wealth in the utility function leads to the discounting to consumer’s Euler equation, enlarging determinacy regions and making it easier for the monetary authority to ensure equilibrium determinacy. We show that a passive policy rule which adjusts nominal interest rate by less than one-for-one in response to the inflation rate is able to rule out equilibrium indeterminacy, if properly specified, due to the presence of the demand channel of the Taylor principle and equilibrium determinacy. Furthermore, the extent to which monetary policy rule can be passive in order to avoid indeterminacy depends critically on the degree of preference over wealth as well as the underlying structures and parameters of the model.

The natural real rate of interest and monetary policy: New evidence for the US

AbstractWe propose a new method to estimate the unobservable natural real rate of interest in the United States (US). We begin by describing the natural rate in the New Keynesian model and then theoretically linking its evolution to both demand and supply‐side shocks hitting the US economy. Our results indicate that the technology shock dominated the shift in the natural real rate of interest during the sample period 1947–2017. In addition, we also examine whether the Taylor rule should be augmented for changes in the estimated natural rate. Our maximum likelihood estimation shows that the inclusion of the natural interest rate shift in the Taylor rule leads to significant improvement of the interest rate modelling.

Unveiling the sentiment behind central bank narratives: A novel deep learning index

This paper proposes a new framework for analyzing the sentiments of central bank narratives. Specifically, we fine-tune a pre-trained BERT model on a dataset of manually annotated sentences on monetary policy stance. We derive a deep learning domain-specific model—BERT central bank sentiment index—ready for sentiment predictions. The proposed index performs similarly to other measures in capturing financial uncertainty. Also, the sentiment index is less noisy and has the ability to forecast the future path of policy stance, augmenting the standard Taylor rule. Finally, compared to other lexicon-based sentiment indicators, our deep learning index has a higher predictive power in anticipating policy rates changes. Our framework enables future possible research in developing more accurate sentiment indicators for central banks in both advanced and emerging countries.

The macroeconomic stabilization of tariff shocks: What is the optimal monetary response?

In the wake of Brexit and Trump trade war, central banks face the need to reconsider the role of monetary policy in managing the inflationary-recessionary effects of hikes in tariffs. Using a New Keynesian model enriched with global value chains and firm dynamics, we show that the optimal monetary response is expansionary. It supports activity and producer prices at the expense of aggravating short-run headline inflation---contrary to the prescription of the standard Taylor rule. This holds all the more when the home currency is dominant in pricing of international trade.

The FOMC’s new individual economic projections and macroeconomic theories

This paper examines whether the economic projections made by individual policymakers of the Federal Open Market Committee (FOMC) are consistent with macroeconomic facts and theories. By analyzing the projections between 2007 and 2017, this paper finds that they are consistent with Okun’s law, revealing a significantly negative relationship between unemployment and output growth projections. The relationship between inflation and unemployment projections associated with the Phillips curve is much weaker and more dispersed. The FOMC’s reaction function is estimated to be consistent with a conventional Taylor rule, with a sufficiently aggressive response to the inflation gap satisfying the Taylor principle and a negative response to the unemployment gap.

Methodological problems in studies on the Taylor rule

This paper raises concerns about the methodological approaches commonly adopted in typical Taylor rule studies. We find that many empirical studies on the Taylor rule do not follow the required econometric procedures. These studies ignore the presence of unit roots, cointegration, and serial correlation in their tests and estimation. The Taylor rule equation is typically estimated in levels. We show that the Taylor rule can be an unbalanced regression that involves a mixture of I(0) and I(1) variables. Spurious regressions may occur if the variables are not cointegrated and the Taylor rule equation is estimated using variables in levels. In addition, empirical models of the Taylor rule commonly include lags of the dependent variable, and equation residuals are serially correlated. The presence of lagged dependent variables and serially correlated residuals will cause biased and inconsistent least squares estimators. To illustrate our arguments, we re-examine two recent papers to point out the econometric problems that are general in typical Taylor rule studies. We show that an inadequate analysis of the time series properties of the individual series and diagnostic checks of the estimated equations can often lead to invalid conclusions about the empirical validity of the Taylor rule. We demonstrate how autoregressive distributed lag methods can overcome these issues and how the equation can be estimated efficiently.

State-level Taylor rule and monetary policy stress

Research background: Taylor rule is a widely adopted approach to follow monetary policy and investigate various mechanisms related to or triggered by monetary policy. To date, no in-depth examination of scale, determinants and spillovers of state-level monetary policy stress, stemming from the Federal Reserve Board?s (Fed?s) policy has been performed. Purpose of the article: This paper aims to investigate the nature of monetary policy stress on US States delivered by the single monetary policy by using a quarterly dataset spanning the years between 1989 and 2017. Methods: We apply a wide array of time series and panel regressions, such as unit root tests, co-integration tests, co-integrating FMOLS and DOLS regressions, and Spatial Panel SAR and SEM models. Findings & value added: When average stress imposed on states is calculated, it is observed that the level of stress is moderate, but the distribution across states is asymmetric. The cross-state determinants behind the average stress show that states with a higher percentage of working-age and highly educated population, as well as those with higher population density and more export-oriented are negatively stressed (i.e. they experience excessively low interest rates), whereas higher unemployment rate contributes to a positive stress (too high interest rates). To the best of our knowledge, the contribution of this paper lies in estimating monetary policy stress at the state level and unveiling some of the determinants of this stress. Moreover, the paper makes the first attempt to empirically test spatial spillovers of the stress, which are indeed found significant and negative.

The behavior of the Taylor rule in the presence of sovereign Sukuks based on the growth rate of the economy: An analysis by DSGE modelling

The aim of this paper is to study the behavior of the Taylor rule in the presence of Sukuks. The New Keynesian model of Gali (2008)/Chapter 3 is used, due to its simplicity and small size. Nevertheless, such a model is suitable for examining the implications of monetary policy in the presence of sovereign Sukuks. The growth rate is used as the rate of return on sovereign Sukuks, which is closest to the profit and loss sharing approach, and is compared to the Gali’s baseline model. The results show that the introduction of sovereign Sukuks mitigates inflation and output gap shocks, but also limits the scope of the Taylor rule. Thus, an increase in the interest rate is offset by a flight of capital from sovereign Sukuks to treasury bonds, while a decrease in the interest rate leads to a flight from treasury bonds to sovereign Sukuks. In the extreme, if the preference for Sukuks is largely dominant, the Taylor rule tends to be obsolete, and vice versa.

Fed communication on financial stability concerns and monetary policy decisions: Revelations from speeches

This paper studies the informational content of speeches of Fed officials, focusing on financial stability, from 1997 to 2018. We construct indicators that measure the intensity and tone of this topic for both Governors and FRB presidents. When added to a standard forward-looking Taylor rule, a higher topic intensity or negative tone is associated with more monetary policy accommodation than implied by the state of the economy. Our results are mainly driven by the sample prior to the global financial crisis and the information in speeches of FRB presidents. We discuss several channels to account for these findings.

The information content of currency option-implied volatilities: implications for ex-ante forecasts of global equity correlations

We use existing currency models, global capital flows, international parity, the Taylor rule, and some simplifying assumptions to derive and empirically test a link between the information contained in currency option-implied volatilities and future global equity correlations. Using data from January 1999 to May 2020, we test our hypothesis and find that exchange rate option-implied volatilities — coupled with one-period ex-post correlations — more accurately predict subsequent world equity market correlations than other models. Our findings have implications for portfolio diversification, forecasts of overall equity portfolio volatility, and portfolio optimization.

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

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

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

Forecasting the exchange rate with the Taylor rule model during times of alternative monetary policies

AbstractThis study aims to incorporate the effects of recently used alternative monetary policies, such as quantitative easing into standard Taylor rule exchange rate models. Using out‐of‐sample forecasting, we determine whether including long‐term government bond yields and shadow interest rates improves on these model's performance. Using data from the Eurozone, Japan, United Kingdom, and United States, we perform out‐of‐sample forecasts using a rolling window; the results suggest that the model with government bond returns performs best against the random walk, although the results vary across countries, particularly when we compare the forecasts with those produced by a version of uncovered interest parity (UIP).

The role of expectations for currency crisis dynamics—The case of the Turkish lira

AbstractThis paper examines whether and how expectations have contributed to the turbulent path of the Turkish lira since 2008. We derive uncertainty measures surrounding gross domestic product (GDP) growth, inflation, the interest rate, and exchange rates based on survey data from Consensus Economics. Our results illustrate that forecasts have affected realized exchange rates and stock market returns via increased uncertainty. We also show that expectations regarding monetary policy have changed throughout the sample period. In line with, a gradual adjustment of expectations professionals have accounted for the violation of the Taylor rule.