The relevance of Taylor rule
In this paper Dean and Schuh conduct two econometric tests to examine whether the Taylor rule is still an adequate representation of monetary policy in macroeconomic models. They use three benchmark macro models that vary in size and degree of structural restrictions for robustness but do not include unconventional monetary policies: 1) a VAR with modest restrictions; 2) the three-variable New Keynesian (NK) model of Clarida, Gali, and Gertler (1999, 2000); and 3) the DSGE model of Smets and Wouters (2007). They use data from FRED, the Federal Reserve Bank of St. Louis’ database, on the output gap constructed with the CBO’s real potential GDP, core PCE inflation, and the short-term policy rate for the period from 1960:Q1 to 2019:Q4. For the first econometric test, they look for structural breaks in 2007:Q3, the boundary between the Great Moderation (1984-2007) and the period between the Great Financial Crisis and the COVID-19 pandemic (2008-2019). The second econometric test is a comparison of results using two monetary policy rates: the standard fed funds and a shadow rate that incorporates elements of unconventional monetary policies. They find:
Three classes of benchmark macroeconomic models exhibit economically and statistically significant breaks in their Taylor Rule and non-policy coefficients after 2007:Q3. Evidence of breaks is stronger and more widespread in the larger DSGE model. The main result pertaining to the Taylor rule is a decline in the strength of the Fed’s response to inflation relative to its response to output, making the Taylor Rule somewhat more similar to its form in the period before the Great Moderation.
Is the Taylor Rule Still an Adequate Representation of Monetary Policy in Macroeconomic Models?
Authors: James Dean, Scott Schuh
From: North Dakota State University, West Virginia University
An alternative set of monetary policy rules
Recent economic literature has shown that following the Taylor principle is problematic when there are sufficiently many hand-to-mouth households, certain financial frictions, or non-rational expectations. Moreover, following the Taylor rule when government debt is high can lead to explosive inflation. In this paper, Tom Holden proposes a set of “robust real rate rules,” which determine inflation via the Fisher equation—the arbitrage relationship between nominal and real bonds, and can achieve stable inflation even when the before mentioned circumstances hold. These “real rate rules” require the central bank to adjust nominal interest rates one-for-one with movements in real interest rates, as well as more than one-for-one with movements in inflation. Towards this goal, the central bank can observe real rates from real (inflation-protected) bonds, such as Treasury Inflation-Protected Securities (TIPS).
Monetary rules with a unit response to real rates achieve this under the weakest possible assumptions about the behavior of households and firms. They are robust to household heterogeneity, hand-to-mouth consumers, non-rational household/firm expectations, active fiscal policy, missing transversality conditions and to any form of intertemporal or nominal-real links.
Robust real rate rules
Author: Tom D. Holden
From: Deutsche Bundesbank
