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Asset Prices in Taylor Rules: Specification, Estimation, and Policy Implications for the ECB

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  • Siklos, Pierre L.
  • Werner, Thomas
  • Bohl, Martin T.

Abstract

This paper estimates standard and extended Taylor rules for core countries in the euro area, namely France, Germany and Italy, as well as for the ECB. Forward, backward and forecast-based rules are estimated for a variety of samples since the late 1970s. We are particularly interested in the impact of adding asset prices to the standard Taylor rule specification. Since forward-looking Taylor rules are usually estimated via GMM we perform extensive tests for over-identifying restrictions and instrument relevance, a practice generally eschewed in previous work. We find that asset prices can be highly relevant as instruments rather than as separate arguments in policy rules. Backwardlooking Taylor rules, however, cannot be rejected outright. Forecast-based rules perform best using the root mean squared error metric but produce coefficients implying that central banks may be too aggressive at fighting inflation. Encompassing tests are therefore required to select the ?best? policy rule and these suggest that policy rules need to have a mix of forward and forecast-based elements. Furthermore too aggressive reactions to stock prices in particular would have led to an implausible monetary policy. Hence, asset prices appear at best to serve as indicators of the direction of interest rates and not as a variable that the ECB directly reacts to. --

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Bibliographic Info

Paper provided by Deutsche Bundesbank, Research Centre in its series Discussion Paper Series 1: Economic Studies with number 2004,22.

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Date of creation: 2004
Date of revision:
Handle: RePEc:zbw:bubdp1:2288

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Keywords: reaction function; asset prices;

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Cited by:
  1. P. Siklos & M. Bohl, 2006. "Asset Prices as Indicators of Euro Area Monetary Policy: An Empirical Assessment of Their Role in a Taylor Rule," Working Papers eg0053, Wilfrid Laurier University, Department of Economics, revised 2006.
  2. Hoffmann, Andreas, 2009. "Fear of depression - Asymmetric monetary policy with respect to asset markets," MPRA Paper 17522, University Library of Munich, Germany.
  3. Hoffmann, Andreas, 2013. "Did the Fed and ECB react asymmetrically with respect to asset market developments?," Journal of Policy Modeling, Elsevier, vol. 35(2), pages 197-211.
  4. Lee, Dong Jin & Son, Jong Chil, 2013. "Nonlinearity and structural breaks in monetary policy rules with stock prices," Economic Modelling, Elsevier, vol. 31(C), pages 1-11.
  5. Merola, Rossana, 2010. "Optimal monetary policy in a small open economy with financial frictions," Discussion Paper Series 1: Economic Studies 2010,01, Deutsche Bundesbank, Research Centre.
  6. Botzen, W.J. Wouter & Marey, Philip S., 2010. "Did the ECB respond to the stock market before the crisis?," Journal of Policy Modeling, Elsevier, vol. 32(3), pages 303-322, May.
  7. Matthew Greenwood-Nimmo & Youngcheol Shin, 2011. "Shifting Preferences at the Fed: Evidence from Rolling Dynamic Multipliers and Impulse Response Analysis," Working Papers 2011-057, Madras School of Economics,Chennai,India.
  8. Dominique Pepin, 2010. "La BCE réagit-elle au prix des actifs financiers ?," Working Papers hal-00963626, HAL.
  9. Bhansali, Vineer & Dorsten, Matthew P. & Wise, Mark B., 2009. "Asymmetric monetary policy and the yield curve," Journal of International Money and Finance, Elsevier, vol. 28(8), pages 1408-1425, December.
  10. Mario Jovanovic & Tobias Zimmermann, 2008. "Stock Market Uncertainty and Monetary Policy Reaction Functions of the Federal Reserve Bank," Ruhr Economic Papers 0077, Rheinisch-Westfälisches Institut für Wirtschaftsforschung, Ruhr-Universität Bochum, Universität Dortmund, Universität Duisburg-Essen.

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