The Perils of Taylor Rules

Since John Taylor's (1993, Carnegie–Rochester Conf. Ser. Publ Policy39, 195–214), seminal paper, a large literature has argued that active interest rate feedback rules, that is, rules that respond to increases in inflation with a more than one-for-one increase in the nominal interest rate, are stabilizing. In this paper, we argue that once the zero bound on nominal interest rates is taken into account, active interest rate feedback rules can easily lead to unexpected consequences. Specifically, we show that even if the steady state at which monetary policy is active is locally the unique equilibrium, typically there exist an infinite number of equilibrium trajectories originating arbitrarily close to that steady state that converge to a liquidity trap, that is, a steady state in which the nominal interest rate is near zero and inflation is possibly negative. Journal of Economic Literature Classification Numbers: E52, E31, E63.