Simple Taylor Rules Policy Rules in SSMMs

90

3.4.1 Simple Taylor Rules

The Taylor rule is a simple, yet robust, description of the relationship between the monetary policy instrument—in this instance, a short term interest rate—and a measure of the inflation gap and deviation of output from its steady-state or natural value. This simple rule of thumb depends on variables that are easily available in a timely fashion. The Taylor rule itself can be estimated by econometric methods. This rule is also able to explain the historical paths of monetary policy instruments in most industrialized countries and it also provides simple guidance to monetary policy-makers. Taylor 1993 has initially shown that the rule with coefficients of 1.5 on inflation and 0.5 on the output gap can explain USA monetary policy starting from 1986 very well 24 . Recent evidence in Taylor 1999, 2000, 2001 indicate that improvements can be achieved by introducing forward-looking measures of inflation, as suggested by Batini et al. 2001, and an exchange rate variable to reflect an open economy dimension, as in Ball 1999 and Svensson 2000, 2003b. The Taylor rule has been examined empirically for some countries. For example, Clarida et al. 1998 estimate a forward-looking Taylor rule see below for the G3 countries USA, Japan, Germany and the E3 countries United Kingdom, France, Italy using the generalized method of moments GMM for the sample period between 1979 to the early 1990s for the G3 and from 1979 to a period prior to the “hard” exchange rate mechanism ERM for the E3. The results have shown that G3 countries respond aggressively to inflation as evidenced by greater than unity coefficients on inflation and 24 Ball 1997 and Svensson 1997c suggested that “optimal weights” that minimize the variances of inflation and the output gap might be higher than the values proposed by Taylor 1993. 91 rather small coefficients for output gaps. On the other hand, E3 countries have below unity coefficients on inflation and it seemed that they followed a disinflation strategy that does not correspond to the Taylor rule. The recent evidence by Nelson 2000, however, implied that the responses to the UK nominal rate of inflation and output gap are very close to Taylor’s 1993 weights during the time period 1992–1997. In short, the Taylor rule provides a good summary of ex-ante central bank behavior and thus gives comprehensive guidance to policy-making by central bankers 25 . The Taylor rule is a mechanical rule that requires only two sets of information, namely, the inflation gap and the output gap. Taylor 1993 suggested a simple rule by which the central bank adjusts the nominal short-term interest rate. The movements of short-term interest rates are captured by this rule according to the deviation of actual inflation from targeted inflation and the level of output relative to the long-run steady- state value thus referred to as the inflation gap and output gap respectively. Originally, Taylor’s specification used current levels of inflation and the output gap, but in practice the information regarding current inflation rate and the output gap are known only with a lag. The following specification of the Taylor rule includes the inflation and output gaps after a lag of one period : 1 1 1 − ∗ − ∗ − ∗ − + − + + = t t t t y y r i π π λ α π 16 25 Questions remain whether the Taylor rule offer a good guide for future monetary policy as pointed out by King 1999. Furthermore, Chote 1996 argued that the Taylor rule is “spuriously precise” in describing the behaviour of monetary policy in several countries. 92 t π is the current period’s inflation rate and ∗ π is the inflation target. ∗ r is the equilibrium real interest rate which is constant in the Taylor rule 26 and ∗ − y y is the output gap. α and λ are the weights given to the output and inflation gaps respectively. This equation shows that the current period’s nominal interest rate, t i , depends on expected inflation as proxied by the last period’s inflation rate, the previous period’s value of the output gap and the last period’s deviation of the inflation rate from its target. As an example of a Taylor rule in the Brazilian SSMM, de Freitas and Muinhos 1999 tested the equation: t t t t y r r β π π α ρ + − + = ∗ − 1 17 Setting α =1.5 and 5 . = β , they found that this Taylor rule yielded a poorer performance as compared to the optimal rule based on a loss-minimizing function. For stability, it is necessary to impose the restriction that α should be greater than unity. They also experimented with different values of α and β and found that as the weights on both the inflation and output gaps are increased, this simple type of rule provides a good alternative to the optimal one as long as the central bank has a strong bias against variability in the level of inflation. 26 Woodford 2001 favors a time-varying real interest rate according to Wicksell’s “natural rate”. 93

3.4.2 Forward-Looking Rules