Rules versus Dictation: A Taylor Rule for Denmark

As Denmark has pegged its currency to the euro, the Danish short-term interest rate is effectively dictated by the European Central Bank (ECB). This implies an inherent risk that the interest rate set by the ECB might fall ’out of sync‘ with respect to the Danish business cycle. In the present paper, I compare the actual interest rate in Denmark during the period 1994-2009 to the interest rate that would have been pre - scribed by the Taylor rule. As the Taylor rule proposes that the interest rate should be adjusted to stabilize output and inflation around their target values, this rate reflects the business cycle situation in Denmark. I find that while the movements in the actual interest rate display a large correlation with those of the Taylor rule rate, the two rates differ substantially from time to time. A high correlation is prevalent especially since 1999, when the euro replaced the D-mark as the currency to which the Danish Krone is pegged. However, a number of episodes can be identified in which the actual interest rate was considerably lower than what would have been prescribed by the Taylor rule. Thus, while the interest rate ’dictated’ by the ECB has not in general been out of sync with the Danish business cycle, it does occasionally display sizeable deviations from the interest rate warranted by the business cycle situation in Denmark.