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Modifying Taylor Reaction Functions in Presence of the Zero-Lower-Bound: Evidence for the ECB and the Fed

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  • Ansgar Belke
  • Jens Klose

Abstract

We propose an alternative way of estimating Taylor reaction functions if the zero-lowerbound on nominal interest rates is binding. This approach relies on tackling the real rather than the nominal interest rate. So if the nominal rate is (close to) zero central banks can influence the inflation expectations via quantitative easing. The unobservable inflation expectations are estimated with a state-space model that additionally generates a timevarying series for the equilibrium real interest rate and the potential output - both needed for estimations of Taylor reaction functions. We test our approach for the ECB and the Fed within the recent crisis. We add other explanatory variables to this modified Taylor reaction function and show that there are substantial differences between the estimated reaction coefficients in the pre- and crisis era for both central banks. While the central banks on both sides of the Atlantic act less inertially, put a smaller weight on the inflation gap, money growth and the risk spread, the response to asset price inflation becomes more pronounced during the crisis. However, the central banks diverge in their response to the output gap and credit growth.

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Bibliographic Info

Paper provided by DIW Berlin, German Institute for Economic Research in its series Discussion Papers of DIW Berlin with number 1218.

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Length: 33 p.
Date of creation: 2012
Date of revision:
Handle: RePEc:diw:diwwpp:dp1218

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Keywords: zero-lower-bound; Federal Reserve; European Central Bank; equilibrium real interest rate; Taylor rule;

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Cited by:
  1. Ansgar Belke, 2014. "Exit Strategies and Their Impact on the Euro Area - A Model Based View," Ruhr Economic Papers, Rheinisch-Westfälisches Institut für Wirtschaftsforschung, Ruhr-Universität Bochum, Universität Dortmund, Universität Duisburg-Essen 0467, Rheinisch-Westfälisches Institut für Wirtschaftsforschung, Ruhr-Universität Bochum, Universität Dortmund, Universität Duisburg-Essen.
  2. Kuper, Gerard & Jacobs, Jan & He, Xiaoli & Ligthart, Jenny, 2013. "On the impact of the global financial crisis on the euro area," Research Report 13011-EEF, University of Groningen, Research Institute SOM (Systems, Organisations and Management).

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