Some Problems with Taylor Rules

Topics: Inflation, Monetary policy, Macroeconomics Pages: 11 (2627 words) Published: March 27, 2011
Some problems with Taylor rules

YUGUANG LIN 870311-T297

1 Taylor rule
Interest rates, inflation rate and real output have always been important factors for the government and its central bank to reexamine the formulation of macroeconomic policy. Their intrinsic links are also concerned issues for the economic circles. People generally believe that monetary policy should respond in a manner that the adjustment of the interest rate could timely reflect the inflation and real output changes, and effectively inhibit price from excessively change to be up or down, and can also help to promote healthy and stable macroeconomic growth. Then John Taylor (1993) proposed a "Taylor rule" is a simple monetary policy around Interest rates on the relationship between inflation and real output. The Taylor rule has become a good reference for central banks to make the actual monetary policy. Taylor rules assumes that the monetary authorities to use monetary policy tools to focus on two key objectives of the main function, inflation gap (the deviation between actual inflation rate and the inflation target level) and the output gap (the deviation between actual output and the potential output). But are Taylor rules good monetary policy? Here, “good monetary policy” should be defined as the conventional meaning of promoting the central bank to stabilize the inflation successfully around a low average level and also level off output with potential output, so called flexible inflation targeting. So what answer could be found in the various literature to supply? According to this

interpretation (Lars E. O. Svensson 2002), an instrument rule (a policy rule) expresses the central bank’s instrument as an explicit function of information available to the central bank. Most of the literature focuses on simple instrument rules, where the instrument is a function of lacking sufficient information available to the central bank. The well known simple instrument rule is the Taylor rule (John Taylor 1993), as follows. The normal form is:

it   t  rt    ( t   t )   y ( y  y t ) * *


In this equation,



the target short-term nominal interest rate. measured by the GDP deflator.


is the rate of inflation as

 t*

is the desired rate of inflation.



is the is the

assumed equilibrium real interest rate.

y t is

the real GDP, and


logarithm of potential output, as determined by a linear trend. In the original formulation, the coefficients inflation target 1993 in US) This instrument rule is better to be used as guideline in Taylor (1993) and more detail in Taylor (2000). Moreover, the deviations from the rules produce a large magnitude of issues in real world. Thus, this paper explores some problems with Taylor rules in the application of monetary policy.

  and  y are 1.5 and 0.5, the

 * is 2%, the average short real interest rate is 2%.(Taylor

2 Theoretical problems with Taylor rules
Taylor Rules logically provide the central bank to use a reference interest rate which is found that the inflation rate is on target and the economy registers its potential income level. This reference interest rate would be reasonably trusted as a neutral interest rate. And policymakers adjust the nominal interest rate that attempt to obtain a real rate which would be higher or lower than the neutral rate, depending on the actual situation. But such a rule still has two theoretical problems need to be solved for the application of monetary policy. The first problem is that if the model used by the policymakers does not include a dynamic IS model, because the neutral interest rate they would accurate. Therefore, the central bank should estimate an interest rate so that the economy would register potential income level in the medium term, when it

should be with a dynamic IS to estimate the rate would maintain the economy at potential growth.( Greenspan 1993, Blinder 1998 and Woodford...
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