Taylor Rule

10 Key excerpts on "Taylor Rule"

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  The Financial Crisis and Federal Reserve Policy

  • L. Thomas(Author)
  • 2011(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  Chapter 11 The Taylor Rule and Evaluation of U.S. Monetary Policy I. Introduction Among economists, a long-standing debate involves the “rules ver- sus discretion” issue in monetary policy. A monetary policy rule is an arrangement in which the central bank announces in advance a specific objective (or objectives) and commits itself to using its policy instruments rigorously to achieve the explicit objective(s). For exam- ple, if a central bank employs an explicit 2 percent inflation target- ing rule, it will raise interest rates when actual or expected inflation exceeds 2 percent, and reduce interest rates when inflation or expected inflation falls below 2 percent. This type of monetary policy regime contrasts with a system of discretionary monetary policy, in which the central bank is given maximum latitude to employ its judgment in conducting policy. Many economists believe that we would be better served if the con- duct of monetary policy were governed by a rule rather than by human discretion. This is particularly true of nations with a history of high inflation. This chapter discusses the rules versus discretion issue as it pertains to monetary policy. It gives special emphasis to a specific rule known as the Taylor Rule, in which the central bank moves its short- term interest rate target in response to discrepancies of actual inflation and output from specific desired levels. After discussing limitations and problems in using the Taylor Rule, it is used as a benchmark to evaluate the actual conduct of U.S. monetary policy in the Great Depression and in more recent times. 194 The Financial Crisis and Federal Reserve Policy II. The Case for a Monetary Policy Rule Proponents of monetary rules offer several arguments in support of their position. First, politicians and policymakers may seek to use monetary policy to further their own political objectives rather than promoting the public interest.

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  Explaining and Forecasting the US Federal Funds Rate

  A Monetary Policy Model for the US

  • M. Clements(Author)
  • 2003(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  Significantly, the Taylor Rule assumes that Fed monetary policy is essentially reactive rather than proactive, in that it responds only to the quarterly GDP data available to the Fed at each FOMC meeting. Taylor himself used final estimates of GDP and inflation for the current quarter. This data however is not available to the FOMC at the time of each meeting. 9 MONETARY POLICY MODELS The Taylor Rule equation Equation 1.1: Taylor Rule % = i + inflation* + 0.5 × (inflation gap) + 0.5 × (output gap) i = natural real interest rate inflation* = actual or expected inflation inflation gap = actual inflation – Fed inflation ‘target’ output gap = actual GDP – trend GDP. Equation 1.1 becomes: Equation 1.2: FFR% = 2% + GDP def + 0.5 × (GDP def – 2%) + 0.5 × (GDP – 3%) As Equation 1.2 shows, Taylor used the GDP deflator as the chosen level of actual inflation, with all data being based on year-on-year growth rates. The GDP deflator was assumed to give a more accurate representation of inflationary pressures in the economy. The coeffi- cients of 0.5 assume that the Fed places equal importance on changes in the inflation gap as it does on changes in the output gap. The first term in the equation is the long term average ‘natural real interest rate’ which was set at a constant of 2 per cent. The model dictates that if inflation is on target and GDP is at its trend level, the prevailing FFR should be 4 per cent. The rate should be raised (lowered) by 1.5 percentage points for every percentage point inflation is above (below) its target of 2 per cent. Meanwhile, the rate should be raised (lowered) by 0.5 percentage points for every percentage point GDP growth is above (below) its trend level. The model highlights how the Fed places more emphasis on observed movements in the inflation rate than changes in the growth rate of GDP.

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  Monetary Policy in the Context of Financial Crisis

  New Challenges and Lessons

  • Fredj Jawadi, William A. Barnett(Authors)
  • 2015(Publication Date)
  • Emerald Group Publishing Limited

    (Publisher)

  Taylor Rule Inertia In practice, the most important term in the empirical Taylor Rule has been one or more lags of the Federal Funds target itself. At a quarterly fre-quency, the sum of these lag coefficients can be 0.8 or even 0.9 (see, e.g., Clarida et al., 2000 ; McCulloch, 2007 ). This means that in fact the FOMC only reacts 10% or 20% to current conditions, and otherwise is just continuing whatever it was doing in the past. Even when it does finally decide that a big change in the target is long overdue, it timidly changes the target only in a series of small steps, typically only 25 basis points per meet-ing. As a result, it tends to keep interest rates too low for too long a time (as in 2001 2004) or too high for too long (as in 2005 2007), with the outcome that it ends up actually increasing their long-run variance and destabilizing the economy. The FOMC should instead act at each meeting in response to its best estimate of current conditions, with no reference to its previous decisions. Of course, estimated current conditions ordinarily change only slowly, with the result that there will still be considerable serial correlation in the Fed’s Fed Funds target. 14 Nevertheless, the lagged target itself should ideally have no explanatory power for the empirical Taylor Rule once the Fed’s estimates of current conditions are taken into account. The Fed does have a much-neglected mandate from Congress to “mod-erate long-term interest rates,” in addition to its better-known goals of “price stability” and “maximizing employment.” 15 However, as noted by Friedman (1968) , the best way to stabilize long-term interest rates is to stabilize inflationary expectations. Under a Taylor Rule policy, this requires aggressively fighting high (or low) inflation with high (or low) short-term 14 See, for example, McCulloch (2007) .

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  Money, Enterprise and Income Distribution

  Towards a macroeconomic theory of capitalism

  • John Smithin(Author)
  • 2008(Publication Date)
  • Routledge

    (Publisher)

  In the fifty-seven years between Simons’s (1936) “Rules versus authorities in monetary policy” and Taylor’s (1993) “Discretion versus policy rules in practice”, monetary policy was usually thought of, by most mainstream academics, in terms of controlling the level or the rate of growth of one or other of the monetary aggregates, or perhaps just controlling the rate of growth of the monetary base. The purpose of this was to control inflation in accordance with the quantity theory of money. A monetary rule would refer to something like mandated limits on the rate of growth or whichever aggregate was thought to be the most likely to achieve this objective. Keynesian and Post Keynesian economists, however, have usually thought of monetary policy in terms of controlling interest rates (an issue that only very belatedly arrived on the orthodox agenda in the mid-1990s), and would be more interested in how monetary policy would affect (say) unemployment or growth than inflation. They would also, to some extent be more likely to favor a discretionary regime rather than a rules-based one. It is true that the modern mainstream monetary theory of the late twentieth and early twenty-first centuries reverted to a neo-Wicksellian regime for monetary policy, in which a short-term interest rate becomes the main monetary policy instrument and the money supply itself becomes endogenous. Nonetheless, when orthodox economists talk about interest rate rules for monetary policy, the presumption is still that the ultimate purpose of the rule is to achieve low inflation, stable inflation or even outright price stability. It remains the standard view that these sorts of things are what monetary policy is all about, rather than any potential impact on the unemployment rate or on economic growth.

  It is interesting to note that at one point Keynes himself actually came close to enunciating something like a “rule” for monetary policy and interest rates. This was in the following passage (originally quoted by Smithin and Wolf 1993, 370), intended as a defense of the proposed Bretton Woods monetary arrangements in a speech to the British parliament in 1944. The defense itself is disingenuous, as to enter a fixed exchange regime (of any kind), is hardly the ideal method of ensuring domestic policy autonomy. Nonetheless, the passage is still interesting, mainly for what it says about interest rates:

  We are determined that, in future the external value of sterling shall conform to its internal value as set by our own domestic policies and not the other way round. Secondly, we intend to retain control of our domestic rate of interest, and keep it as low as suits our own purposes

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  Monetary Policy Rules

  • John B. Taylor(Author)
  • 2007(Publication Date)
  • University of Chicago Press

    (Publisher)

  This helps to clarify why the design of arrangements under which such a rule could be credible could have significant benefits. Another respect in which our conclusions differ from Taylor’s proposal is that we find little gain from making interest rates depend on the current level of economic activity. We find that optimal rules within our simple families involve a small positive response to the level of detrended output, but it is much more modest than the sort of response suggested by Taylor, or indicated by our estimate of actual U.S. policy. The reason it is undesirable to respond to output deviations, in our model, is that deviations of output from trend have so little to do with deviations of output from potential (which, according to our esti- 111 Interest Rate Rules in an Estimated Sticky Price Model mates, is quite volatile). It is possible that an alternative interpretation of the residuals in our aggregate supply equation, under which they would not all represent variations in the eflcient level of output, would increase the role for responses to output variations in an optimal rule. Alternatively, it is possible that if we considered other real variables (such as employment) along with variations in detrended output, we would be able to construct a better proxy for deviations of output from potential (as proposed, e.g., by McCallum and Nelson in chap. 1 of this volume), to which it would be desirable for interest rates to respond. Finally, our results shed light on the debate about the relative advantages of price level targeting and inflation targeting. We find that under a desirable pol- icy, the central bank should consistently act to subsequently reverse any move- ments of inflation above its target level, rather than simply preventing further price increases without undoing the ones that have already occurred.

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  Monetary Policy, Inflation, and the Business Cycle

  An Introduction to the New Keynesian Framework and Its Applications - Second Edition

  • Jordi Galí(Author)
  • 2015(Publication Date)
  • Princeton University Press

    (Publisher)

  κ in the case of the forward-looking rule).

  The practical shortcomings of optimal interest rate rules discussed above have led many authors to propose a variety of “simple rules”—understood as rules that a central bank could arguably adopt in practice—and to analyze their properties.8 In that context, an interest rate rule is generally considered “simple” if it makes the policy instrument a function of observable variables only, and does not require any precise knowledge of the exact model or the values taken by its parameters. The desirability of any given simple rule is thus given to a large extent by its robustness, that is, its ability to yield a good performance across different models and parameter configurations.

  In the following section, two such simple rules are analyzed—a simple Taylor-type rule and a constant money growth rule—and their performance is assessed in the context of our baseline New Keynesian model.

  4.4

  T WO S IMPLE M ONETARY P OLICY R ULES

  This section provides an illustration of how the basic New Keynesian model developed in chapter 3 can be used to assess the performance of two policy rules. A formal evaluation of the performance of a simple rule (relative, say, to the optimal rule or to an alternative simple rule) requires the use of some quantitative criterion. Following the seminal work of Rotemberg and Woodford (1999), much of the literature has adopted a welfare-based criterion, relying on a second-order approximation to the utility losses experienced by the representative consumer as a consequence of deviations from the efficient allocation. As shown in appendix 4.1 , under the assumptions made in this chapter (which guarantee the optimality of the flexible price equilibrium), that approximation yields the following welfare loss function

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  Current Issues in Turkish Economics

  Problems and Policy Suggestions

  • Çaglar Yurtseven, Mahmut Tekce(Authors)
  • 2019(Publication Date)
  • Peter Lang Group

    (Publisher)

  Taylor Rule for Turkey under Multiple Structural Breaks 23 2011, respectively. The last period is between 2011:11 and 2018:08. In this period, the CBRT conducts a non-orthodox monetary policy. All coefficients are signif- icant. The coefficient of the inflation gap is higher than it is in the two previous periods. The sign of output gap is also positive and significant. This, in turn, implies that during the last period, the CBRT followed a very cautious monetary policy that aimed to combat inflation and smooth the business cycle. 4 Conclusion Quite a few studies estimate the Taylor Rule for the CBRT. Even though the Turkish economy experienced many structural changes since 2002, the previous studies that estimate the monetary policy rule for Turkey disregard structural breaks while fitting a policy reaction function. In this study, we adopt the Bai and Perron’s (2003) structural break-testing procedure that allows us to find the struc- tural breaks with unknown dates while using a Two-Stage Least Squares (2SLS) method to deal with the endogeneity problem of the Taylor-rule estimation. Our results show that there are four different monetary policy periods which are 2002:03 – 2004:08, 2004:09 – 2008:11, 2008:12 – 2011:10, and 2011:11 – 2018:08. In the first period, only the smoothing parameter is significant in our estimated Taylor Rule. In the second period, the deviance of inflation expectations from the inflation target also becomes significant, and the output gap remains insignificant. This result indicates that the CBRT’s main focus was on inflation and disregarded the growth. In the third period, the coefficient of the inflation gap gets smaller, and the sign of the output gap becomes negative and significant. According to these results, the CBRT seems to pursue pro-cycle monetary policy with less focus on inflation between 2008:12 and 2011:10.

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  Macro And Micro Policies For More Growth And Employment

  • Herbert Giersch(Author)
  • 2019(Publication Date)
  • Taylor & Francis

    (Publisher)

  The reason for the rather loose relationship was simply that the standard errors in those vector autoregressions are fairly high. It was suggested that nominal interest rates should not be used as instruments because one does not know by simply looking at them whether they are high or low; such uncertainty would not exist for the judgement on the growth of the monetary base. 96 The difference between the proposed rule and a price level rule was stressed by several participants. In their opinion, a policy following McCallum's rule had the advantage that it would not react to an adverse supply shock with monetary tightness. This, however, would be required according to a price level rule, and the effect would be that the negative short-term real effects of a real shock on the economy would be exaggerated. In the McCallum rule, the supply shocks would be allowed to work through changes in the price level; in the medium run, how-ever, inflation would not be affected. What are the general characteristics of policy rules, and how can they be made effective? An important problem for policymakers is, of course, that at certain in - periods, policy options that have sub-optimal consequences in the long run (time inconsistency) may become optimal. The analogy of the flood , as described in Alan Blinder's paper, raises the problem of moral hazard: if the government were to intervene and pluck those people off the roofs who insited on building their houses in endangered areas, their behavior would indeed be encouraged. This is one of the crucial issues in the rules-versus-discretion debate and finds its parallel in, for example, stabilization policy when the central bank has to decide whether it should accommodate excessive wage increases.

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  Inflation Theory in Economics

  Welfare, Velocity, Growth and Business Cycles

  • Max Gillman(Author)
  • 2009(Publication Date)
  • Taylor & Francis

    (Publisher)

  Treatise, and it suggests that Keynes’s price and business cycle analysis has some consistency not only with the neoclassical real business cycle theory but also with the recent neo-classical policy prescriptions for the supply of money.

  16.7 Conclusions and qualifications

  The chapter contributes a Treatise-motivated construction of a cross analysis that frames the Treatise’s equilibrium theory of business cycles. The fiscal policy of this construction shows that income rises when government spending increases as in the standard cross analysis only if it is assumed that the total cost schedule does not pivot up. This qualification is argued also to be applicable to the IS-LM fiscal policy results. Then the chapter replaces the Treatise’s specification of profit with a Marshallian definition. While lacking any of the standard cross-type fiscal policy results, this allows derivation of AS-AD from an extended total-revenue/total-cost framework, and of comparative statics of a change in productivity as in a business cycle. The total cost/total revenue approach also suggests investigating whether profit constitutes the exogenous technology shock in cycle theory.

  The chapter stands in contrast to the discussion of Keynes’s concepts in Patinkin (1976 : 8), who wants to ‘try to avoid the temptation to translate them into modern concepts’. And while Patinkin at the same time argues that Keynes focuses ineffectively on the fundamental equations in the Treatise,28 here an attempt to develop relevance for modern concepts is derived from a focus on Keynes’s equation for the theory of aggregate price. Such a focus on the mathematical structure of a theory can be particularly worthwhile because it forces clarification of the issues to such a point that they can more easily be advanced. And here the advancement is that the Treatise’s theory when corrected seems to contain an insufficiently explored element of neo-classical analysis. In the neoclassical real business cycle theory there generally is no profit per se because of the constant-returns-to-scale assumption for production. There is only an increase and decrease in the marginal products of factors, leading Mankiw (1989) to suggest that such negative shocks other than oil shocks have never been seen.29 But clearly negative profits have always been seen and continue to be identified. And a profit increase is the manifestation of how capital has a higher yield, while ‘restructuring’ that writes off capital losses is the manifestation of how capital has a lower yield. Therefore it remains a potentially worthwhile endeavour to sort out the profit contribution to the marginal product change. In a way that seems suggested by the Treatise

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  Central Bank Policy

  Theory and Practice

  • Perry Warjiyo, Solikin M. Juhro(Authors)
  • 2019(Publication Date)
  • Emerald Publishing Limited

    (Publisher)

  Third , NKPC and IS Curve behavior are fundamentally already in equilibrium, thus interaction between the two is theoretically in equilibrium. Nonetheless, a system with forward-looking expectations triggers multiple equilibria as a form of behavior or expectations, which directly or indirectly become self-fulfilling expectations identified in the rational expectations model. Such conditions create indeterminacy. From a general perspective, the problem of indeterminacy can be overcome by proposing an active policy rule design, namely with a reaction parameter of the policy rate to changes in inflation of more than 1. Therefore, the presence of a policy rule that emerges as the third equation is the optimal policy rule design, which is typically oriented toward efforts to achieve system stability in line with prevailing policy commitment.
• Fourth , the central bank’s preference, be it inflation or output stability, will influence the impact of the monetary policy taken. Theoretically, strict ITF application, where λ = 0, will provide a larger short-term impact on inflation, output and interest rates compared to flexible ITF, where λ ≠ 0.
8.2.2.2. ITF in the Inflation Forecast Targeting Format.