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The perils of Taylor Rules

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  • Jess Benhabib

    ()
    (New York University)

  • Stephanie Schmitt-Grohe

    ()
    (Rutgers University)

  • Martin Uribe

    ()
    (University of Pennsylvania)

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, in the context of a sticky-price model, 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 either to another steady state at which monetary policy is passive or to a stable limit cycle around the active steady state. We conclude that the use of local techniques for monetary policy evaluation might lead to spurious policy recommendations.

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Bibliographic Info

Paper provided by Rutgers University, Department of Economics in its series Departmental Working Papers with number 199831.

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Date of creation: 09 Nov 1998
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Handle: RePEc:rut:rutres:199831

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Keywords: Interest rate feedback rules; liquidity traps; multiple equilibria; zero bound on nominal rates;

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References

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  1. 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.
  2. Julio J. Rotemberg & Michael Woodford, 1998. "Interest-Rate Rules in an Estimated Sticky Price Model," NBER Working Papers 6618, National Bureau of Economic Research, Inc.
  3. 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.
  4. Stephanie Schmitt-Grohe & Jess Benhabib & Martin Uribe, 2001. "Monetary Policy and Multiple Equilibria," American Economic Review, American Economic Association, vol. 91(1), pages 167-186, March.
  5. John B. Taylor, 1998. "An Historical Analysis of Monetary Policy Rules," NBER Working Papers 6768, National Bureau of Economic Research, Inc.
  6. Lucas, Robert E, Jr & Stokey, Nancy L, 1987. "Money and Interest in a Cash-in-Advance Economy," Econometrica, Econometric Society, vol. 55(3), pages 491-513, May.
  7. Richard Clarida & Jordi Gali & Mark Gertler, 1998. "Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory," NBER Working Papers 6442, National Bureau of Economic Research, Inc.
  8. Sbordone, A.M., 1998. "Prices and Unit Labor Costs: a New Test of Price Stickiness," Papers 653, Stockholm - International Economic Studies.
  9. 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.).
  10. Bernanke, Ben S & Woodford, Michael, 1997. "Inflation Forecasts and Monetary Policy," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 29(4), pages 653-84, November.
  11. Taylor, John B., 1998. "The Robustness and Efficiency of Monetary Policy Rules as Guidelines for Interest Rate Setting by the European Central Bank," Seminar Papers 649, Stockholm University, Institute for International Economic Studies.
  12. Edward C. Prescott, 1986. "Theory ahead of business cycle measurement," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall, pages 9-22.
  13. 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.).
  14. 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.
  15. 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.
  16. 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.
  17. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
  18. Michael Woodford, 1996. "Control of the Public Debt: A Requirement for Price Stability?," NBER Working Papers 5684, National Bureau of Economic Research, Inc.
  19. 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.
  20. 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.
  21. 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.
  22. 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.
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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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