Different Between Adaptive and Rational Expectation

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Working Paper No. 00-01-01

Are Policy Rules Better than the Discretionary System in Taiwan? James P. Cover
C. James Hueng and Ruey Yau

Are Policy Rules Better than the Discretionary System in Taiwan?

James Peery Cover Department of Economics, Finance, and Legal Studies University of Alabama Phone: 205-348-8977 Fax: 205-348-0590 Email: jcover@cba.ua.edu C. James Hueng Department of Economics, Finance, and Legal Studies University of Alabama Phone: 205-348-8971 Fax: 205-348-0590 Email: chueng@cba.ua.edu and Ruey Yau Department of Economics Fu-Jen Catholic University Taiwan Phone: 619-534-8904 Fax: 619-534-7040 Email: ryau@weber.ucsd.edu

Correspondence to:

C. James Hueng Department of Economics, Finance, and Legal Studies University of Alabama, Box 870224 Tuscaloosa, AL 35487 Phone: 205-348-8971 Fax: 205-348-0590 Email: chueng@cba.ua.edu

Are Policy Rules Better than the Discretionary System in Taiwan?

ABSTRACT This paper investigates whether the central bank of Taiwan would have had a more successful monetary policy during the period 1971:1 to 1997:4 if it had followed an optimal rule rather than the discretionary policies that were actually employed. The paper examines the use of two different instruments—the discount rate and the monetary base—with several different targets — growth of nominal output, inflation, the exchange rate, and the money growth. The results show that most of the rules considered would not have significantly improved the performance of the Taiwanese economy. The only rule that is clearly advantageous is one that targets inflation while using the interest rate instrument.

Keywords: monetary policy rule, small open economy, dynamic programming JEL classification: E52, F41

1. Introduction How well has the Central Bank of Taiwan implemented monetary policy during the past three decades? With the exception of two inflationary episodes during periods of oil-price shocks (1973-1974 and 1979-1981), as far as inflation is concerned, the historical record suggests that monetary policy in Taiwan has been very successful. Figure 1 shows that during other periods the rate of inflation in Taiwan typically has been relatively low, nearly always being between 2% and 7% per year. But could the Central Bank of Taiwan have performed much better than it actually did? That is, could it have achieved a lower and less variable rate of inflation at little or no cost in terms of lost output? Because Taiwanese monetary policy has been discretionary, rather than based on a formal rule, there is a strand of macroeconomic theory that suggests the answer to this question must be yes. If the structure of the Taiwanese economy is such that an unexpected increase in the rate of inflation causes output to increase, then policy makers have an incentive to increase inflation. This implies that a discretionary monetary policy will have an inflationary bias [Kydland and Prescott (1977) and Barro (1986)]. The existence of this inflationary bias makes it difficult for policy makers to lower expected inflation without first earning a reputation for price stability. If the only way to earn this reputation is through actually achieving low inflation, then the cost of reducing inflation is a significant loss of output. A solution to this reputation or credibility problem is for the monetary authority to follow an explicit formal rule that eliminates its discretion to inflate. It therefore follows that a monetary policy implemented according to a rule will achieve lower inflation than a discretionary monetary policy. For example, Judd and Motley (1991, 1992, 1993) and McCallum (1988) have examined the empirical properties of nominal feedback rules and find that the use of simple feedback rules could have produced price stability for the United States over the past several decades without significantly increasing the volatility of real output.

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This paper examines whether the central bank of Taiwan would have...
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