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(Taylor) Rules versus Discretion in U.S. Monetary Policy

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  • Alex Nikolsko-Rzhevskyy

    ()
    (Lehigh University)

  • David Papell

    ()

  • Ruxandra Prodan

    ()

Abstract

The Taylor rule has been the dominant metric for monetary policy evaluation over the past 20 years, and it has become common practice to identify periods where policy either adheres closely to or deviates from the Taylor rule benchmark. The purpose of this paper is to identify (Taylor) rules-based and discretionary eras solely from the data so that knowledge of subsequent economic outcomes cannot influence the choice of the dates. We define Taylor rules-based and discretionary eras by smaller and larger Taylor rule deviations, the absolute value of the difference between the actual federal funds rate and the federal funds rate prescribed by the original Taylor rule, and use tests for multiple structural changes and Markov switching models to identify the eras. Monetary policy in the U.S. is characterized by a Taylor rules-based (low deviations) era until 1974, a discretionary (high deviations) era from 1974 to about 1985, a rules-based era from about 1985 to 2000, and a discretionary era from 2001 to 2008. The Taylor rule deviations are about three times as large in the discretionary eras than in the rules-based eras and are almost four times larger in the most discretionary era (1974 to 1984) than in the least discretionary era (1985 to 2000). With the Markov switching models, which allow for regime changes at the beginning and end of the sample, we also identify a discretionary era from 1965 to 1968 and a rules-based era in 2006 and 2007. The discretionary and rules-based eras closely correspond to periods where the Taylor rule deviations are above and below two percent.

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File URL: http://www.uh.edu/econpapers/RePEc/hou/wpaper/2013-198-44.pdf
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Bibliographic Info

Paper provided by Department of Economics, University of Houston in its series Working Papers with number 2013-198-44.

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Date of creation: 17 Jul 2013
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Handle: RePEc:hou:wpaper:2013-198-44

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Postal: Houston TX 77023
Web page: http://www.uh.edu/class/economics/
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Keywords: Taylor rules; rules versus discretion; monetary policy;

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References

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  1. Athanasios Orphanides, 1998. "Monetary policy rules based on real-time data," Finance and Economics Discussion Series 1998-03, Board of Governors of the Federal Reserve System (U.S.).
  2. Nikolsko-Rzhevskyy, Alex & Papell, David H., 2012. "Taylor rules and the Great Inflation," Journal of Macroeconomics, Elsevier, vol. 34(4), pages 903-918.
  3. Hamilton, James D, 1989. "A New Approach to the Economic Analysis of Nonstationary Time Series and the Business Cycle," Econometrica, Econometric Society, vol. 57(2), pages 357-84, March.
  4. Christopher A. Sims & Tao Zha, 2004. "Were there regime switches in U.S. monetary policy?," Working Paper 2004-14, Federal Reserve Bank of Atlanta.
  5. Zheng Liu & Daniel F. Waggoner & Tao Zha, 2011. "Sources of macroeconomic fluctuations: A regime‐switching DSGE approach," Quantitative Economics, Econometric Society, vol. 2(2), pages 251-301, 07.
  6. Perron, P. & Bai, J., 1995. "Estimating and Testing Linear Models with Multiple Structural Changes," Cahiers de recherche 9552, Centre interuniversitaire de recherche en économie quantitative, CIREQ.
  7. Kydland, Finn E & Prescott, Edward C, 1977. "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 473-91, June.
  8. Perron, Pierre & Qu, Zhongjun, 2006. "Estimating restricted structural change models," Journal of Econometrics, Elsevier, vol. 134(2), pages 373-399, October.
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