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"Taylored rules". Does one fit (or hide) all?

Modern monetary policymakers consider a huge amount of information to evaluate events and contingencies. Yet most research on monetary policy relies on simple instrument rules and one relevant underpinning for this choice is the good empirical fit of the Taylor rule. This paper challenges the solidness of this foundation. We investigate the way the coefficients of the Taylor-type rules change over time according to the evolution of general economic conditions. We model the Federal Reserve reaction function during the Greenspan’s tenure as a Logistic Smoothing Transition Regime model in which a series of economic meaningful transition variables drive the transition across monetary regimes. We argue that estimated linear rules are weighted averages of the actual rules working in the diverse monetary regimes, where the weights merely reflect the length and not necessarily the relevance of the regimes. Accordingly, an estimated linear Taylor-type reaction function tends to resemble the rule adopted in the longest regime. Thus, the actual presence of finer monetary policy regimes corrupts the general predictive and descriptive power of linear Taylor-type rules. These latter, by hiding the specific rules at work in the various finer regimes, lose utility directly with the uncertainty in the economy.

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Paper provided by Economics Section, The Graduate Institute of International Studies in its series IHEID Working Papers with number 04-2005.

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Length: 69 pages
Date of creation: 01 Sep 2005
Date of revision: Apr 2006
Handle: RePEc:gii:giihei:heiwp04-2005
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  2. Duffy, John & Engle-Warnick, Jim, 2006. "Multiple Regimes in U.S. Monetary Policy? A Nonparametric Approach," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 38(5), pages 1363-1377, August.
  3. Lars E O Svensson, 2005. "Monetary Policy with Judgment: Forecast Targeting," International Journal of Central Banking, International Journal of Central Banking, vol. 1(1), May.
  4. Clarida, R. & Gali, J. & Gertler, M., 1998. "Monetary Policy Rules and Macroeconomic Stability: Evidence and some Theory," Working Papers 98-01, C.V. Starr Center for Applied Economics, New York University.
  5. Mehtap Kesriyeli & Denise R. Osborn & Marianne Sensier, 2004. "Nonlinearity and Structural Change in Interest Rate Reaction Functions for the US, UK and Germany," Working Papers 0414, Research and Monetary Policy Department, Central Bank of the Republic of Turkey.
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  8. David Gruen & Michael Plumb & Andrew Stone, 2003. "How Should Monetary Policy Respond to Asset-price Bubbles?," RBA Annual Conference Volume, in: Anthony Richards & Tim Robinson (ed.), Asset Prices and Monetary Policy Reserve Bank of Australia.
  9. Tim Robinson & Andrew Stone, 2006. "Monetary Policy, Asset-Price Bubbles, and the Zero Lower Bound," NBER Chapters, in: Monetary Policy with Very Low Inflation in the Pacific Rim, NBER-EASE, Volume 15, pages 43-90 National Bureau of Economic Research, Inc.
  10. Welz, Peter & Österholm, Pär, 2005. "Interest Rate Smoothing versus Serially Correlated Errors in Taylor Rules: Testing the Tests," Working Paper Series 2005:14, Uppsala University, Department of Economics.
  11. Ben S. Bernanke & Mark Gertler, 2001. "Should Central Banks Respond to Movements in Asset Prices?," American Economic Review, American Economic Association, vol. 91(2), pages 253-257, May.
  12. Robert J. Tetlow & Peter von zur Muehlen, 2002. "Monetary Policy, Asset Prices, and Misspecification: the robust approach to bubbles with model uncertainty," Computing in Economics and Finance 2002 335, Society for Computational Economics.
  13. Brian Sack & Volker Wieland, 1999. "Interest-rate smoothing and optimal monetary policy: a review of recent empirical evidence," Finance and Economics Discussion Series 1999-39, Board of Governors of the Federal Reserve System (U.S.).
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  15. Lars E. O. Svensson, 2003. "What Is Wrong with Taylor Rules? Using Judgment in Monetary Policy through Targeting Rules," Journal of Economic Literature, American Economic Association, vol. 41(2), pages 426-477, June.
  16. Robert B. Davies, 2002. "Hypothesis testing when a nuisance parameter is present only under the alternative: Linear model case," Biometrika, Biometrika Trust, vol. 89(2), pages 484-489, June.
  17. Antonello D'Agostino & Luca Sala & Paolo Surico, 2005. "The Fed and the Stock Market," Macroeconomics 0507001, EconWPA.
  18. Roberto Rigobon & Brian Sack, 2003. "Measuring The Reaction Of Monetary Policy To The Stock Market," The Quarterly Journal of Economics, MIT Press, vol. 118(2), pages 639-669, May.
  19. Charles R. Bean, 2004. "Asset Prices, Financial Instability, and Monetary Policy," American Economic Review, American Economic Association, vol. 94(2), pages 14-18, May.
  20. Sharon Kozicki, 1999. "How useful are Taylor rules for monetary policy?," Economic Review, Federal Reserve Bank of Kansas City, issue Q II, pages 5-33.
  21. Granger, Clive W J, 1993. "Strategies for Modelling Nonlinear Time-Series Relationships," The Economic Record, The Economic Society of Australia, vol. 69(206), pages 233-38, September.
  22. Philip Lowe & Luci Ellis, 1997. "The Smoothing of Official Interest Rates," RBA Annual Conference Volume, in: Philip Lowe (ed.), Monetary Policy and Inflation Targeting Reserve Bank of Australia.
  23. James B. Bullard & Eric Schaling, 2002. "Why the Fed should ignore the stock market," Review, Federal Reserve Bank of St. Louis, issue Mar., pages 35-42.
  24. DETKEN Carsten & SMETS Frank, . "Asset Price Booms and Monetary Policy," EcoMod2003 330700042, EcoMod.
  25. Jagjit S. Chadha & Lucio Sarno & Giorgio Valente, 2004. "Monetary Policy Rules, Asset Prices, and Exchange Rates," IMF Staff Papers, Palgrave Macmillan, vol. 51(3), pages 529-552, November.
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