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Can central banks' monetary policy be described by a linear (augmented) Taylor rule or by a nonlinear rule?

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  • Vítor, Castro

Abstract

The original Taylor rule establishes a simple linear relation between the interest rate, inflation and the output gap. An important extension to this rule is the assumption of a forward-looking behaviour of central banks. Now they are assumed to target expected inflation and output gap instead of current values of these variables. Using a forward-looking monetary policy reaction function, this paper analyses whether central banks' monetary policy can indeed be described by a linear Taylor rule or, instead, by a nonlinear rule. It also analyses whether that rule can be augmented with a financial conditions index containing information from some asset prices and financial variables. The results indicate that the monetary behaviour of the European Central Bank and Bank of England is best described by a nonlinear rule, but the behaviour of the Federal Reserve of the United States can be well described by a linear Taylor rule. Our evidence also suggests that only the European Central Bank is reacting to financial conditions.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Financial Stability.

Volume (Year): 7 (2011)
Issue (Month): 4 (December)
Pages: 228-246

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Handle: RePEc:eee:finsta:v:7:y:2011:i:4:p:228-246

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Web page: http://www.elsevier.com/locate/jfstabil

Related research

Keywords: Monetary policy Nonlinear Taylor rule Financial conditions index Smooth transition regression model;

References

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