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The Perils of Taylor Rules

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  • Benhabib, Jess
  • Schmitt-Grohé, Stephanie
  • Uribe, Martín

Abstract

Since John Taylor's (1993) seminal paper, a large literature has argued that active interest rate feedback rules, that is, rules that respond to increases in inflation with a more than one-for-one increase in the nominal interest rate, are stabilizing. In this paper, we argue that once the zero bound on nominal interest rates is taken into account, active interest rate feedback rules can easily lead to unexpected consequences. Specifically, we show that even if the steady state at which monetary policy is active, is locally the unique equilibrium, typically there exists an infinite number of equilibrium trajectories originating arbitrarily close to that steady state, that converge to a liquidity trap, that is, a steady state in which the nominal interest rate is near zero and inflation is possibly negative.

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Bibliographic Info

Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 2314.

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Date of creation: Dec 1999
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Handle: RePEc:cpr:ceprdp:2314

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Related research

Keywords: Interest Rate Feedback Rules; Liquidity Trap; Zero Bound On Nominal Interest Rates;

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References

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  1. Paul R. Krugman, 1998. "It's Baaack: Japan's Slump and the Return of the Liquidity Trap," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 29(2), pages 137-206.
  2. Robert E. Lucas Jr. & Nancy L. Stokey, 1984. "Money and Interest in Cash-In-Advance Economy," Discussion Papers 628, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  3. Argia M. Sbordone, 2001. "Prices and Unit Labor Costs: A New Test of Price Stickiness," Departmental Working Papers 199822, Rutgers University, Department of Economics.
  4. Julio Rotemberg & Michael Woodford, 1997. "An Optimization-Based Econometric Framework for the Evaluation of Monetary Policy," NBER Chapters, in: NBER Macroeconomics Annual 1997, Volume 12, pages 297-361 National Bureau of Economic Research, Inc.
  5. Andrew Levin & Volker Wieland & John C. Williams, 1998. "Robustness of simple monetary policy rules under model uncertainty," Finance and Economics Discussion Series 1998-45, Board of Governors of the Federal Reserve System (U.S.).
  6. Richard Clarida & Jordi Gali & Mark Gertler, 1997. "Monetary Policy Rules in Practice: Some International Evidence," NBER Working Papers 6254, National Bureau of Economic Research, Inc.
  7. Edward C. Prescott, 1986. "Theory ahead of business cycle measurement," Staff Report 102, Federal Reserve Bank of Minneapolis.
  8. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
  9. Richard Clarida & Jordi Galí & Mark Gertler, 2000. "Monetary Policy Rules And Macroeconomic Stability: Evidence And Some Theory," The Quarterly Journal of Economics, MIT Press, vol. 115(1), pages 147-180, February.
  10. Schmitt-Grohe, Stephanie & Uribe, Martin, 2000. "Price level determinacy and monetary policy under a balanced-budget requirement," Journal of Monetary Economics, Elsevier, vol. 45(1), pages 211-246, February.
  11. Yun, Tack, 1996. "Nominal price rigidity, money supply endogeneity, and business cycles," Journal of Monetary Economics, Elsevier, vol. 37(2-3), pages 345-370, April.
  12. Julio J. Rotemberg & Michael Woodford, 1999. "Interest Rate Rules in an Estimated Sticky Price Model," NBER Chapters, in: Monetary Policy Rules, pages 57-126 National Bureau of Economic Research, Inc.
  13. Ben S. Bernanke & Michael Woodford, 1997. "Inflation Forecasts and Monetary Policy," NBER Working Papers 6157, National Bureau of Economic Research, Inc.
  14. Taylor, John B., 1999. "The robustness and efficiency of monetary policy rules as guidelines for interest rate setting by the European central bank," Journal of Monetary Economics, Elsevier, vol. 43(3), pages 655-679, June.
  15. Taylor, J.B., 1998. "The Robustness and Efficiency of Monetary Policy Rules as Guidelines for Interest Rate Setting by European Central Bank," Papers 649, Stockholm - International Economic Studies.
  16. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
  17. Jess Benhabib & Stephanie Schmitt-Grohe & Martin Uribe, 1999. "Monetary Policy and Multiple Equilibria," Departmental Working Papers 199914, Rutgers University, Department of Economics.
  18. Rotemberg, Julio J, 1982. "Sticky Prices in the United States," Journal of Political Economy, University of Chicago Press, vol. 90(6), pages 1187-1211, December.
  19. Susanto Basu & John G. Fernald, 1996. "Returns to scale in U.S. production: estimates and implications," International Finance Discussion Papers 546, Board of Governors of the Federal Reserve System (U.S.).
  20. John B. Taylor, 1998. "An Historical Analysis of Monetary Policy Rules," NBER Working Papers 6768, National Bureau of Economic Research, Inc.
  21. Michael Woodford, 1996. "Control of the Public Debt: A Requirement for Price Stability?," NBER Working Papers 5684, National Bureau of Economic Research, Inc.
  22. Leeper, Eric M., 1991. "Equilibria under 'active' and 'passive' monetary and fiscal policies," Journal of Monetary Economics, Elsevier, vol. 27(1), pages 129-147, February.
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Citations

Blog mentions

As found by EconAcademics.org, the blog aggregator for Economics research:
  1. Is it time for the Fed to raise its policy rate?
    by David Andolfatto in MacroMania on 2013-01-20 02:18:00
  2. On the perils of Taylor rules
    by David Andolfatto in MacroMania on 2012-12-28 20:20:00
  3. Connecting the Academic and Policy Worlds: Interview with James Bullard
    by David Andolfatto in MacroMania on 2013-11-25 21:40:00
  4. Is QE lowering the rate of inflation?
    by David Andolfatto in MacroMania on 2013-12-01 18:54:00
  5. Deflation in Sweden: Svensson's Advice is the Problem, Not the Solution
    by Stephen Williamson in Stephen Williamson: New Monetarist Economics on 2014-04-20 20:05:00
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  1. Advanced Monetary Theory and Policy (ECON 447)

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