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Taylor Rule and Financial Instability

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  • Gianfranco Zampese

Abstract

This paper estimates an augmented/non-linear Taylor rule for the ECB and the Riksbank to include financial instability factors. The existence of nonlinearities will be explored and assessed through the estimation of a threshold regression model. The threshold model divides the sample in two distinct subsamples, each representative of a different regime. A composite indicator of systemic stress characterizes the two regimes into a low instability regime and a high instability regime. The results are quite clear. They show us that the classical Taylor rule performs well during Regime 1, or “normal administration times"; but it shows inherently weaknesses in describing the behavior of CBs during financial instability periods, when discretion may be necessary. Remarkably such a non-linear model is also successful in not crossing the ZLB.

Suggested Citation

  • Gianfranco Zampese, 2017. "Taylor Rule and Financial Instability," BAFFI CAREFIN Working Papers 1757, BAFFI CAREFIN, Centre for Applied Research on International Markets Banking Finance and Regulation, Universita' Bocconi, Milano, Italy.
    • Handle: RePEc:baf:cbafwp:cbafwp1757
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    Cited by:

    1. Naveen Srinivasan & Parush Arora, 2020. "If Monetary Aggregates, then Divisia," Working Papers 2020-192, Madras School of Economics,Chennai,India.

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