Taylor Rule Research Articles

Do Fed Forecast Errors Matter?

There is a large literature evaluating the forecasts of the Federal Reserve by testing their rationality and measuring the size of their forecast errors. There is also a substantial literature and debate on the impact of the Fed’s monetary policy on the economy. We know little, however about the impact of the Fed’s forecast errors on economic outcomes. This paper constructs a measure of a forecast error shock for the Federal Reserve based on the assumption that the Fed follows a forward-looking Taylor rule. Given the effort the Fed puts towards producing forecasts that do not have an endogenous error component, we treat the Fed’s forecast errors as a shock, analogous to a monetary policy shock. Our shock, however, is different in that it is completely unintended by the monetary authority rather than simply unanticipated by the public. We follow Romer and Romer (2004) and investigate the effect of the forecast error shock on output and price movements. Our results suggest that although the absolute magnitude of the forecast error shock is large, the impact of the shock on the macroeconomy is quite small. This finding is robust across a range of different specifications. The maximum impact suggests a decline of less than 0.3 percent of real GDP and less than 0.4 percent of GDP deflator in response to a 100 basis point contractionary forecast error shock.

Monetary and Macro-Prudential Mandates in a New Keynesian Behavioural Framework

This paper examines the conduct of optimal monetary and macro-prudential mandates in a behavioural bounded rationality framework with a financial friction in form of the collateral constraint. A mandate framework is designed where each macroeconomic regulator is assigned a distinct objective function, is instrument-independent and the welfare-optimal parameters of these delegated mandate are computed. Cooperative and non-cooperative mandates games between the monetary and macro-prudential regulation are studied and comparisons drawn between results for rational expectations (RE) and BR models. The main results are: first, in a Bayesian likelihood race the BR model easily outperforms the RE model. Second, the BR model has much larger region of determinacy compared with RE; i.e., the Taylor principle is easier to satisfy under BR. Third, forward guidance is much less powerful under the BR model; i.e., the “forward-guidance puzzle is resolved. Finally, we confirm a common result in this literature that monetary and macro-prudential cooperation is welfare reducing compared with non-cooperation.

The Central Bank Governor and Interest Rate Setting by Committee

Abstract This article studies the role of central bank governors in monetary policy decisions taken by a committee. To carry out this analysis, we constructed a novel dataset of committee voting behaviour for six OECD countries for up to three decades. Using a range of Taylor rule specifications, we show that a change in governor significantly affects interest rate setting. We also observe systematic differences in interest rate rules based on the political party appointing the governor, with more inflation-averse policies under governors that are appointed by a right-wing political authority. We show the robustness of this result by using a wider dataset (including over 3000 observations from 12 countries). (JEL codes: E02, E5, P16)

Key interest rate in optimal monetary policy in Ukraine

In the paper, the empirical examine of Taylor rule use in case of Ukraine has presented. The obtained results has shown that the most significant influence on interest rate makes inflation rate and interest rate in previous period. It had been found that 1% change of consumption prices and interest rate in previous period increases interest rate by 1,28 and 0,71% respectively. Instead 1% change in GDP gap causes only 0,04% change in interest rate. The obtained results has shown that 1% change of inflation gap provoke National Bank of Ukraine to increase interest rate by 0,8%.

Monetary Policy Rule and Taylor Principle in Mongolia: GMM and DSGE Approaches

This article aims to examine the monetary policy rule under an inflation targeting in Mongolia with a focus on its conformity to the Taylor principle, through two kinds of approaches: a monetary policy reaction function by the generalized-method-of-moments (GMM) estimation and a New Keynesian dynamic stochastic general equilibrium (DSGE) model with a small open economy version by the Bayesian estimation. The main findings are summarized as follows. First, the GMM estimation identified an inflation-responsive rule fulfilling the Taylor principle in the recent phase of the Mongolian inflation targeting. Second, the DSGE-model estimation endorsed the GMM estimation by producing a consistent outcome on the Mongolian monetary policy rule. Third, the Mongolian rule was estimated to have a weaker response to inflation than the rules of the other emerging Asian adopters of an inflation targeting.

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.

Taming the Housing Crisis: An LTV Macroprudential Policy

This paper develops a DSGE framework featuring a heterogeneous housing market, endogenous default, and a banking sector. We find that the idiosyncratic mortgage risk shock plays an important role in explaining the fluctuations of house prices during the mid-1980s and the years leading up to the financial crisis. The same shock is also one of the main driving forces of household loans. By placing an occasionally binding constraint on the loan-to-value ratio, we find that the overheating of the housing economy in the early 2000s and the subsequent crash could have been alleviated, if authorities had adopted such a macroprudential policy measure. A welfare comparison indicates that the maximum loan-to-value policy is preferable over an augmented Taylor rule that responds to house price growth.

The effects of the monetary policy on the U.S. housing boom from 2001 to 2006

This paper presents a DSGE model to test the relative significance of monetary policy and financial market innovations in creating the U.S. housing boom between 2001 and 2006. The model generates a trajectory of house price that mimics the Case–Shiller index well when actual Federal Fund rates are taken as inputs. It fails to do so when the monetary policy follows the Taylor rule even if MBS are introduced. We identify several transmission mechanisms of monetary policy with an emphasis on the financial accelerator. The model predicts that banks’ lending standards will go down with the benchmark interest rate.

How Do People Interpret Macroeconomic Shocks? Evidence from U.S. Survey Data

AbstractWe study the revision of survey expectations in response to macroeconomic shocks, which we identify in vector autoregressive models with sign restrictions. We find that survey respondents distinguish between movements along the Phillips curve and shifts of the Phillips curve, depending on the type of shock that hits the economy. In addition, interest rate expectations are revised broadly in line with a Taylor rule. Consistent with models of rational inattention, macroeconomic shocks account for a small share of the forecast error variance of survey measures elicited from consumers, while they are more relevant for the expectations of professional forecasters.

Imperfecciones en los mercados financieros y la regla óptima de tasas de interés

Este trabajo presenta un modelo teórico útil para encontrar la regla de tasas de interés que minimiza una función que depende de la varianza del producto y la varianza de la inflación. En condiciones ideales esta regla respeta el principio de Taylor, por el cual la tasa nominal de interés de política se sobre ajusta a la inflación y sus expectativas. Sinembargo, en presencia de mercados imperfectos de crédito y/o de un numeroso grupo de personas excluido del sector financiero, la regla óptima puede no respetar el principio mencionado. Aun en estos casos, el modelo macroeconómico presenta trayectorias estables y definidas para la inflación y el producto.

E-stability vis-à-vis determinacy in regime-switching models

This paper examines E-stability, determinacy, and indeterminacy in a general class of regime-switching models with lagged endogenous variables. Using determinacy conditions from Cho (2016, 2020), our first result extends McCallum (2007) to models with time-varying parameters: the unique mean-square stable equilibrium is E-stable if agents have current information and one-period-ahead decision rules. Further, we address the existence of E-stable non-fundamental equilibria, and find that Iteratively E-stable equilibria of indeterminate switching models can exist. Finally, we show that indeterminate New Keynesian models with persistent, recurring interest rate peg regimes admit Iteratively E-stable equilibria. In special cases, the Iterative E-stability condition coincides with the Long Run Taylor Principle.

Forward guidance and quantitative easing at the Zero Lower Bound

This paper uses the Sims and Wu (2020) New Keynesian model to derive the optimal combinations of forward guidance policies and quantitative easing (QE) at the Zero Lower Bound. We also illustrate how a Taylor Rule, with an optimally chosen inflation target, implements forward guidance, when quantitative easing eliminates the financial friction. We find that the theorem for the Taylor rule implementation of optimal forward guidance in Chattopadhyay and Daniel (2018) is robust in the Sims and Wu (2020) New Keynesian model when QE completely eliminates the financial friction.

SVAR (Mis)Identification and the Real Effects of Monetary Policy Shocks

I argue that the seemingly disparate findings of the recent empirical literature on monetary policy transmission are all consistent with the same standard macro models. Weak sign restrictions, which suggest that contractionary monetary policy, if anything, boosts output, present as policy shocks what actually are expansionary demand and supply shocks. Classical zero restrictions are robust to such misidentification, but miss short-horizon effects. Two recent approaches—restrictions on Taylor rules and external instruments—instead work well. My findings suggest that empirical evidence is consistent with models in which the real effects of monetary policy are larger than commonly estimated. (JEL C32, E12, E32, E43, E52)

The European Central Bank’s monetary pillar after the financial crisis

Abstract We apply a structural topic model (STM) to analyze European Central Bank (ECB) communication regarding the monetary pillar of its monetary policy strategy. We do so by quantifying the transcripts of the ECB President’s introductory statements at the press conferences that accompany the regular meetings of the ECB Governing Council. Our evidence shows that, within its monetary pillar, the ECB has gradually shifted its focus away from a genuine monetary analysis towards monitoring the stability of the European financial system. We go on to augment a standard Taylor rule by quantitative indicators obtained from the STM to assess whether the monetary pillar in general, and the shift in focus in particular, has had a measurable impact on the ECB’s monetary policy stance. We find that the monetary analysis has had a bearing on the interest rate setting in the early years of the ECB’s existence, but this influence completely disappears in the latter years of the sample. Furthermore, we find no evidence that financial stability considerations in the ECB communication have influenced interest rate decisions either before or after the financial crisis.

Revisiting Monetary Policy Reaction Function in Developing Economies: Multiscale-GMM Evidence of Policy Asymmetry from Ghana

We estimate monetary policy reaction function for Ghana to comprehend the policy behaviour of Bank of Ghana (BOG) over the years using Generalized Methods of Moment technique within wavelet multiscale domain. The empirical results show an overriding evidence of asymmetry monetary policy rule in Ghana across the historical time domain and multiscale spectrum. The time-domain analysis reveals a generally weak policy response to overall output gap, while the multiscale result points to a statistically significant policy reaction to output gap in the short-run. The extent of policy easing during economic downturn appears to be stronger in the long run while policy tightening during economic booms is rather substantial in the short-to-medium run. On the other hand, policy response to inflation is stronger in the medium-to-long run and there is a compelling evidence of policy aversion to positive inflation gap. Yet, the magnitude of policy response to above-target (rising) inflation is well below unity across timescales, pointing to a clear non-adherence to the Taylor principle and by extension, a pursuit of flexible inflation targeting regime in Ghana. Notably, there is further robust evidence of high policy inertia, while the direct inclusion of exchange rate in the monetary policy rule appears to be superfluous in the context of Ghana. Moreover, monetary policy reaction to macroeconomic dynamics is however found to be homogenous across political regimes, construing lack of political regime-effect on monetary policy reaction function for Ghana. The empirical results thus transmit important and diverse policy implications for the central bank of Ghana to safeguard the price stability objective.

How macroeconomists lost control of stabilization policy: towards dark ages

This paper is a study of the history of the transplant of mathematical tools using negative feedback for macroeconomic stabilisation policy from 1948 to 1975 and the subsequent break of the use of control for stabilisation policy which occurred from 1975 to 1993. New-classical macroeconomists selected a subset of the tools of control that favoured their support of rules against discretionary stabilisation policy. The Lucas critique and Kydland and Prescott’s time-inconsistency were over-statements that led to the “dark ages” of the prevalence of the stabilisation-policy-ineffectiveness idea. These over-statements were later revised following the success of the Taylor rule.

Should Inequality Factor into Central Banks' Decisions?

Inequality is increasingly a concern. Fiscal and structural policies are well-understood mitigators. However, less is known about the potential role of monetary policy. This paper investigates how inequality matters for monetary policy within a tractable Two-Agent New Keynesian model that captures important dimensions of inequality. We find some support for making inequality an explicit target for monetary policy, particularly if central banks follow standard Taylor rules.

Testing for asymmetry in monetary policy rule for small-open developing economies: Multiscale Bayesian quantile evidence from Ghana

Ghana’s consumer inflation has remained persistently high above its medium-term target despite officially practicing inflation targeting regime for over a decade. This paper examines how the Central Bank of Ghana has reacted to deviations of inflation and output gap from their respective desired levels over the past one and half decades. Primarily, it ascertains whether monetary policy in Ghana can be more precisely described by either (i) the standard linear Taylor rule, or (ii) an augmented linear rule including exchange rate or (iii) a nonlinear augmented threshold rule. The paper applies versions of frequentist and Bayesian quantile regressions at both time- and multiscale domains along with the standard threshold regression framework. The basic result is that the augmented nonlinear (threshold) Taylor rule describes the dynamics of interest rate settings in Ghana better than the linear rule. There is high degree of monetary policy inertia and an overriding aversion for rising inflation (above target). The authority shows greater tendency to react strongly to above-target inflation in the medium-to-longer term than in the short-term. We find that the Bank of Ghana is more aggressive toward inflation than output growth and does not react to the real economy independently from its concerns about inflation. The exchange rate has important influence on interest rate in the low inflation regime. We find an accommodative policy response to positive deviation of inflation from target even at the long run. Such policy passivity possibly underpins the persistently high inflation in Ghana as other policy interventions have not succeeded in taming inflation over the years.

Fed Communication on Financial Stability Concerns and Monetary Policy Decisions: Revelations from Speeches

This paper studies the informational content of publicly given speeches of FOMC members with a focus on financial stability, from 1997 to 2018. We document that presidents of Federal Reserve Banks spoke more than Board members around and after the financial crisis, and exhibit more variation in the topics of their speeches. Our speech-based indicators of financial stability-related topics show that, when added to a standard forward-looking Taylor rule, a higher speech intensity on these topics relates to a more accommodative monetary policy. This result is driven by the information in speeches of Fed presidents, not the Board or the Fed Chair. We discuss several channels that can rationalize this finding.

Disinflation costs in China and monetary policy regimes

This paper investigates the real effects of a disinflationary policy in China, in which we conduct a disinflation experiment in a medium-scale New Keynesian model. We highlight two key features of China's economy: the relevance of money to monetary policy rules and household inequality. For the former, we consider two monetary policy regimes: an expanded Taylor rule with money and a money supply rule. For the latter, we take into account a share of the population that is limited in its ability to participate in assets markets. Our analysis suggests that a disinflation policy is more costly when the central bank controls the money supply than the case in which the nominal interest rate is the policy instrument. Our results are driven by the different impacts of disinflation on nominal and real interest rates under the two regimes.