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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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  3. 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.
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  8. David Gruen & Michael Plumb & Andrew Stone, 2005. "How Should Monetary Policy Respond to Asset-Price Bubbles?," International Journal of Central Banking, International Journal of Central Banking, vol. 1(3), December.
  9. 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.
  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. Owyang, Michael T. & Ramey, Garey, 2001. "Regime Switching and Monetary Policy Measurement," University of California at San Diego, Economics Working Paper Series qt24q32688, Department of Economics, UC San Diego.
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  17. Roberto Rigobon & Brian Sack, 2001. "Measuring the reaction of monetary policy to the stock market," Finance and Economics Discussion Series 2001-14, Board of Governors of the Federal Reserve System (U.S.).
  18. 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.
  19. Castelnuovo, Efrem, 2003. "Taylor rules, omitted variables, and interest rate smoothing in the US," Economics Letters, Elsevier, vol. 81(1), pages 55-59, October.
  20. Paolo Surico & Antonello D'Agostino & Luca Sala, 2005. "The Fed and the Stock Market," Computing in Economics and Finance 2005 293, Society for Computational Economics.
  21. 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.
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  23. 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.
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  25. 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.
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  27. 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.
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