An empirical evaluation of China’s monetary policies

This paper investigates the responsiveness of the Chinese government’s monetary policies in terms of the money supply and interest rates to economic conditions and the effectiveness of these policies in achieving the goals of stimulating economic growth and controlling inflation. We analyze the responsiveness and effectiveness by estimating the Taylor rule, the McCallum rule, and a vector autoregressive model using quarterly data in the period of 1992-2009. The results show that, overall, the monetary policy variables respond to economic growth and the inflation rate, but the magnitudes of the responses are much weaker than those observed in market economies. Money supply responded actively to both the inflation rate and the real output and had certain effects on the future inflation rates and real output. The official interest rates, on the other hand, responded passively to the inflation rate and did not respond to the real output. They do not have any effect on future inflation rates and real output either.     

Is the monetary policy rule responsive to exchange rate changes? The case of Indonesia,Malaysia, the Philippines,and Thailand

Extending Obstfeld and Rogoff (J Econ Perspect 9:73–96, 1995), Ball (Monetary policy rules, University of Chicago Press, pp. 127–144, 1999), Svensson (J Int Econ 50: 155–183, 2000), Taylor (Am Econ Rev 91: 263–267, 2001), Gali and Gertler (J Econ Perspect 21:25–46, 2007), and others, this paper finds that central banks in the Philippines and Thailand respond negatively to the current real exchange rate and positively to the lagged real exchange rate whereas central banks in Indonesia and Malaysia do not react to the current or lagged real exchange rate. For the Philippines and Thailand, the null hypothesis that the sum of the coefficients of the current and lagged real exchange rates is zero cannot be rejected at the 5% level. Central banks in these four countries respond positively to the inflation rate and the output gap, suggesting that the concept of a simple or an extended Taylor rule would apply to these countries. Monetary policy reaction functions for Indonesia and Thailand are steeper than those for Malaysia and the Philippines and would be more responsive to a change in the inflation rate.      

TARGETS IN THE TAYLOR RULE: INFLATION,SPEED LIMIT,OR PRICE LEVEL?

This paper explores the link between alternative targets in the Taylor rule and their empirical fit using real‐time U.S. macroeconomic data. We first study the stabilizing properties of the classical Taylor rule (inflation targeting, IT) and add either a price‐level target (PLT) or output gap quasigrowth target (speed‐limit targeting, SLT) in the context of the standard New Keynesian model. We demonstrate that, although only SLT has the same functional form as the optimal interest‐rate reaction function, both PLT and SLT stabilize the model macroeconomy against a cost‐push shock for a wide range of parameter values better than IT. We then estimate all three specifications using the Greenbook data. We find much stronger support for SLT than PLT and discuss pitfalls in estimating the latter that are present in existing literature. (JEL E52, E58)     

TAYLOR RULE REACTION COEFFICIENTS AND REAL EXCHANGE RATE PERSISTENCE

Recent literature has established a link between the persistence of real exchange rates and the degree of inertia in Taylor rule monetary policy reactions functions. This paper provides a different view on this link by investigating how the size of Taylor rule reaction coefficients impacts the adjustment dynamics of the real exchange rate. Within a stylized sticky‐price open‐economy macro model, it is demonstrated that a stronger interest rate reaction to inflation in the Taylor rule raises the convergence speed of the real exchange rate. Conversely, raising the coefficient on the output gap or attending to the exchange rate in an open‐economy version of the Taylor rule slows down real exchange rate adjustment. In all cases, more rapid convergence comes at the cost of stronger initial real exchange rate misalignments in the wake of monetary policy shocks.     

Is the Taylor Rule Really Different from the McCallum Rule?

When base velocity is a stable function of the Federal funds rate (FFR), the money base–nominal GDP targeting rule (McCallum rule) can be reparameterized and presented in terms of FFR as the policy instrument. Comparison of this McCallum modified policy rule with the popular Taylor rule suggests that these two rules and the FFR are actually closely related. Model-based evaluations of the two rules' stabilization properties indicate that the modified McCallum rule is similar to the Taylor rule. The key to this result is the degree of interest rate smoothing applied to the policy rules. (JEL E3 , E52 , E58 )     

The Taylor Rule and Dynamic Stability in a Small Macroeconomic Model

In this paper, we embed the Taylor interest rate rule in a simple macroeconomic model with Calvo contracts. We contrast this with the case in which the interest rate is determined by the conventional LM curve along with a fixed value for the monetary aggregate. We derive conditions under which the adjustment of the economy is characterized by a unique saddle–path and show that the conditions required for this to be the case are more stringent when the authorities adopt the Taylor rule. In both cases, the possible failure of the saddle–path condition arises when there are debt–deflation effects in the IS curve. If interest rates are set according to the Taylor rule, then debt–deflation is always enough to cause the failure of the saddle–path condition. However, when interest rates are determined by the LM curve then it is possible that the real balance effect from the LM curve may offset the debt–deflation effect and produce a saddle–path.
(J.E.L. E4, E5).     

Output gap uncertainty: Does it matter for the Taylor rule?

This paper analyses the effect of measurement error in the output gap on efficient monetary policy rules in a simple estimated model of the US economy. While it is a well-known result that such additive uncertainty does not affect the optimal feedback rule in a linear-quadratic framework, it is shown that output gap uncertainty can have a significant effect on the efficient response coefficients in restricted instrument rules such as the popular Taylor rule. Output gap uncertainty reduces the response to the current estimated output gap relative to current inflation and may partly explain why the parameters in estimated Taylor rules are often much less than what optimal control exercises which assume the state of the economy is known suggest. First version received: September 2000/Final version received: February 2001     

Central bank inability and Taylor rule in developing countries

This paper seeks to adjust Taylor rule to mimic an environment that has central bank inability (losses). Moreover, the current paper is aiming at investigating the effect of the new features of Taylor rule within a context of a New-Keynesian model on a developing economy. The current paper concludes that we can utilize Taylor rule within a New-Keynesian model to introduce the influence of the central bank inability on the economy. Central bank inability decreases both expected future real interest rate and expected future real output. On the contrary, it increases expected future nominal interest rate and expected future inflation rate. Moreover, we prove that the effect of central bank inability has larger effect on the expected inflation rate more than the influence of targeted inflation rate.     

Sources of exchange rate fluctuations with Taylor rule fundamentals

This paper investigates the sources of exchange rate fluctuations when monetary policy follows a Taylor rule interest rate reaction function. We first present a simple dynamic exchange rate model with Taylor rule fundamentals which is triangular in the long-run impacts of shocks to the output market, the interest rate differential, and the Taylor rule. We then proceed to assess the relative importance of various shocks in exchange rate determination by estimating a structural VAR with long-run identification restrictions based on the triangular structure of the model. We find demand shocks to be less important than in earlier VAR studies, with both supply shocks and nominal shocks explaining a substantial part of real exchange rate fluctuations.     

Monetary transmission mechanism in Turkey under the monetary conditions index: an alternative policy rule

This study analyses monetary transmission mechanism in Turkey using a small structural macroeconomic model. The core equations of the model consist of aggregate demand, wage-price setting, uncovered interest rate parity, foreign sector and a monetary policy rule. The aim of the paper is to analyse the disinflation path, the output gap, the output level, the exchange rate and the interest rate, and also the output–inflation variance frontier of the economy under various scenarios. The first scenario assumes that a standard Taylor rule is implemented as the policy rule. In the alternative scenario, instead of the standard Taylor rule, the MCI, Monetary Conditions Index – combination of the changes in the short-term real interest rate and in the real effective exchange rate in a single variable – is used as a policy instrument. The results indicate that the economy stabilizes much more quickly and shows significantly less volatility under this new setting. Therefore, the paper concludes that the policymakers should consider using MCI as an instrument when conducting monetary policy.     

Endogenous monetary policy and the liquidity effect

We compare the transmission mechanism of exogenous and endogenous monetary policies in a calibrated small open economy model with nominal and real rigidities. Under an exogenous monetary policy rule it takes implausible values of the intertemporal elasticity of substitution and the price adjustment costs to generate the liquidity and overshooting effects. Endogenous rules with strong feedback to inflation and output help to reproduce the response of the nominal interest and exchange rates to unanticipated monetary policy shocks that characterize the transmission mechanism of standard sticky price models. The liquidty and overshooting effects are always obtained when the model is augmented with a Taylor interest rate rule.JEL Classification: E32, E43Javier Andrés acknowledges support of CICYT grant SEC2002-0026. We thank the comments of two anonymous referees and the editor, Jordi Caballé, to an earlier version of the paper. The views expressed here are those of the authors and do not represent the view of the Banco de España.     

Macroeconomic dynamics in Macedonia and Slovakia: Structural estimation and comparison

This paper estimates a structural macroeconomic model using data for Macedonia and Slovakia to characterize possible challenges Macedonia can face concerning macroeconomic stabilization during its transition process. A comparison of the estimated model parameters suggests that, in Slovakia, the output gap is less sensitive to real interest rate movements and prices experience greater inertia. The estimated monetary policy reaction functions show Macedonia and Slovakia as inflation targeters, with Macedonia as the more conservative one, despite its officially applied exchange rate targeting regime. The differences in the estimated parameters imply differing transmission mechanisms for Macedonia and Slovakia. Consequently, the variance of domestic variables in Slovakia is most influenced by monetary policy shocks, while there is no single dominating shock explaining the volatility of Macedonia's macroeconomic variables. The exchange rate shock, the monetary policy shock and the demand shock are jointly important in determining the volatility of Macedonia's variables. The model simulations indicate that Macedonia experiences lower output gap and inflation volatility than Slovakia. This comes, nevertheless, at the cost of higher interest rate and real exchange rate volatility in Macedonia, which could be an indication of more volatile financial markets with possible negative implications for financial stability.     

Real exchange rate dynamics: Relative importance of Taylor‐rule fundamentals,monetary policy shocks,and risk‐premium shocks

We first show that the solution to the real exchange rate under the Taylor rule with interest rate smoothing can have two alternative representations—one based on a first‐order difference equation and the other based on a second‐order difference equation. Then, by comparing error terms from these two alternative representations and analyzing their second moments, we evaluate the relative importance of Taylor‐rule fundamentals, monetary policy shocks, and risk‐premium shocks in the dynamics of the real exchange rate. Empirical results suggest that the risk‐premium shock is the largest contributor to real exchange rate movements for all the countries examined, with the Taylor‐rule fundamentals and monetary policy shocks playing a limited role. These results are robust to various alternative sets of parameter values considered for the Taylor rule with interest rate smoothing.     

How the ECB and the US Fed set interest rates

Monetary policies of the European Central Bank (ECB) and US Fed can be characterized by ‘Taylor rules’, that is both central banks seem to be setting rates by taking into account the ‘output gap’ and inflation. We also set up and tested Taylor rules which incorporate money growth and the euro–dollar exchange rate, thereby improving the ‘fit’ between actual and Taylor rule based rates. In general, Taylor rules appear to be a much better way of describing Fed policy than ECB policy. Simulations suggest that the ECB's short-term interest rates have been at a much lower level in the last 2 years compared with what a Taylor rule would suggest.     

DO POLITICS CAUSE REGIME SHIFTS IN MONETARY POLICY?

Whether or not politics cause changes in monetary policy is controversial in the literature. This article re‐examines the link between politics and regime shifts in monetary policy using two alternative approaches. First, empirical results show that both the presidential and Federal Reserve Bank (Fed) chairmanship regimes do not influence monetary policy under the assumption that the Fed closely follows an interest rate rule. On the other hand, evidence also suggests that changes in political regimes are able to account for the deviations from the optimal Taylor rule. (JEL E52, E58, D78)     

The natural rate of interest and the output gap in the euro area: a joint estimation

The notion of a natural real rate of interest, due to Wicksell (Interest and prices. Macmillan, London Translation of 1898 edition, 1936), is widely used in current central bank research. The idea is that there exists a level at which the real interest rate would be compatible with output at its potential level and stationary inflation. Such a concept is of primary concern for monetary policy because it provides a benchmark for the monetary policy stance. This paper applies the method suggested by Laubach and Williams (Rev Econ Stat 85(4):1063–1070, 2003) to jointly estimate the natural real interest rate and the output gap in the euro area using data from 1960 onwards. Our results suggest that the natural real rate of interest has declined gradually over the past 40 years. They also indicate that monetary policy in the euro area was on average stimulative during the 1960s and the 1970s, while it contributed to dampen the output gap and inflation in the 1980s and 1990s. The views expressed in this paper are those of the authors and do not necessarily reflect the opinions of the institutions to which they are affiliated. We are grateful to Siem Jan Koopman for very helpful suggestions and comments. We also thank P. Cour-Thimann, V. Curdia, F. Drudi, S. McCaw, D. Rodriguez-Palenzuela, R. Pilegaard, H. Pill, L. Stracca, T. Laubach, J. C. Williams and the participants of an ECB workshop on natural interest rates.     

Taylor rules and the Great Inflation

Can US monetary policy in the 1970s be described by a stabilizing Taylor rule when policy is evaluated with real-time inflation and output gap data? Using economic research on the full employment level of unemployment and the natural rate of unemployment published between 1970 and 1977 to construct real-time output gap measures for periods of peak unemployment, we find that the Federal Reserve did not follow a Taylor rule if appropriate measures are used. We estimate Taylor rules and find no evidence that monetary policy stabilized inflation, even allowing for changes in the inflation target. While monetary policy was stabilizing with respect to inflation forecasts, the forecasts systematically under-predicted inflation following the 1970s recessions and this does not constitute evidence of stabilizing policy. We also find that the Federal Reserve responded too strongly to negative output gaps.     

Why inflation targeting central banks seem to follow a standard Taylor rule

Central banks only caring about inflation stability seem to follow a standard Taylor rule. The alleged reaction to the output gap could be a reaction of the nominal interest rate to variations in the natural real rate of interest.     

Interest rates,government purchases and the Taylor rule in recessions and expansions

In this paper we study asymmetries in the Taylor rule for the United States during the 1970–2012 period. We show that monetary authorities have been constantly concerned with excess demand in overheated periods – when the output gap is positive or the unemployment rate falls below 7% or 7.5% – raising the interest rate aggressively in that case. However, the Fed seems more reluctant to decrease the fund’s rate during recessions. On the contrary, monetary authorities react symmetrically and forcefully to inflation in booms and busts. Finally, we provide evidence that an expansionary fiscal policy does not lead to an increase in interest rates, and thus there is not necessary a “crowding-out” effect in recessions.     

Real wage rigidities and optimal monetary policy in a small open economy

The main objective of the study is to provide a theoretical analysis of optimal monetary policy in a small open economy where households set real wage in a staggered fashion. The introduction of real wage rigidities plays a important role to resolve main shortcomings of the standard new Keynesian small open economy model. The main findings regarding the issue of monetary policy design can be summarized as three fold. First, the optimal policy is to seek to minimize variance of domestic price inflation, real wage inflation, and the output gap if both domestic price and real wage are sticky. Second, controlling CPI inflation directly or indirectly induces relatively large volatility in output gap and other inflations. Therefore, both CPI inflation-based Taylor rule and nominal wage-inflation based Taylor rule are suboptimal. Last, a policy that responds to a real wage inflation is most desirable.