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Generalizing the Taylor Principle

  • Troy Davig
  • Eric M. Leeper

The paper generalizes the Taylor principle—the proposition that central banks can stabilize the macroeconomy by raising their interest rate instrument more than one-for-one in response to higher inflation—to an environment in which reaction coefficients in the monetary policy rule change regime, evolving according to a Markov process. We derive a long-run Taylor principle which delivers unique bounded equilibria in two standard models. Policy can satisfy the Taylor principle in the long run, even while deviating from it substantially for brief periods or modestly for prolonged periods. Macroeconomic volatility can be higher in periods when the Taylor principle is not satisfied, not because of indeterminacy, but because monetary policy amplifies the impacts of fundamental shocks. Regime change alters the qualitative and quantitative predictions of a conventional new Keynesian model, yielding fresh interpretations of existing empirical work. (JEL E31, E43, E52)

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Article provided by American Economic Association in its journal American Economic Review.

Volume (Year): 97 (2007)
Issue (Month): 3 (June)
Pages: 607-635

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Handle: RePEc:aea:aecrev:v:97:y:2007:i:3:p:607-635
Note: DOI: 10.1257/aer.97.3.607
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