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

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We analyse the effect of uncertainty concerning the state and the nature of asset price movements on the optimal monetary policy response. Uncertainty is modelled 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 NIPE - Universidade do Minho in its series NIPE Working Papers with number 15/2008.

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Date of creation: 2008
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Handle: RePEc:nip:nipewp:15/2008

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Keywords: Asset Prices; Monetary Policy; Markov Switching.;

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  1. Andrew Levin & John C. Williams, 2000. "The Performance of Forecast-Based Monetary Policy Rules under Model Uncertainty," Econometric Society World Congress 2000 Contributed Papers 1781, Econometric Society.
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Cited by:
  1. Paulo Bastos & Natália P. Monteiro, 2011. "Managers and Wage Policies," Journal of Economics & Management Strategy, Wiley Blackwell, vol. 20(4), pages 957-984, December.
  2. Alexandre, Fernando & Portela, Miguel & Sá, Carla, 2008. "Admission Conditions and Graduates' Employability," IZA Discussion Papers 3530, Institute for the Study of Labor (IZA).
  3. Alexandre, Fernando & Bação, Pedro & Gabriel, Vasco, 2010. "Soft landing in a Markov-switching economy," Economics Letters, Elsevier, vol. 107(2), pages 169-172, May.

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