Taylor-type rules versus optimal policy in a Markov-switching economy

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Taylor-type rules versus optimal policy in a Markov-switching economy

Author Info

Fernando Alexandre (NIPE and University of Minho)
Pedro Bação () (GEMF and Faculdade de Economia, Universidade de Coimbra)
Vasco Gabriel (Department of Economics, University of Surrey, UK and NIPE-UM)

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Abstract

We analyse the effect of uncertainty concerning the state and the nature of asset price movements on the optimal monetary policy response. Uncertainty is modeled by adding Markov-switching shocks to a DSGE model with capital accumulation. In our analysis we consider both Taylor-type rules and optimal policy. Taylor rules have been shown to provide a good description of US monetary policy. Deviations from its implied interest rates have been associated with risks of financial disruptions. Whereas interest rates in Taylor-type rules respond to a small subset of information, optimal policy considers all state variables and shocks. Our results suggest that, when a bubble bursts, the Taylor rule fails to achieve a soft landing, contrary to the optimal policy.

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Paper provided by GEMF - Faculdade de Economia, Universidade de Coimbra in its series GEMF Working Papers with number 2008-02.

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Length: 37 pages
Date of creation: 2008
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Handle: RePEc:gmf:wpaper:2008-02

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Paper
- Fernando Alexandre & Vasco J. Gabriel & Pedro Bação, 2008. "Taylor-type rules versus optimal policy in a Markov-switching economy," NIPE Working Papers 15/2008, NIPE - Universidade do Minho. [Downloadable!]
- Fernando Alexandre & Pedro Bação & Vasco Gabriel, 2008. "Taylor-type rules versus optimal policy in a Markov-switching economy¤," Department of Economics Discussion Papers 0608, Department of Economics, University of Surrey. [Downloadable!]

Find related papers by JEL classification:
E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies

This paper has been announced in the following NEP Reports:

NEP-ALL-2008-05-10 (All new papers)
NEP-CBA-2008-05-10 (Central Banking)
NEP-MAC-2008-05-10 (Macroeconomics)
NEP-MON-2008-05-10 (Monetary Economics)

References listed on IDEAS
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