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Taylor-type rules versus optimal policy in a Markov-switching economy

  • Fernando Alexandre

    (NIPE and University of Minho)

  • Pedro Bação

    ()

    (GEMF and Faculdade de Economia, Universidade de Coimbra)

  • Vasco Gabriel

    (Department of Economics, University of Surrey, UK and NIPE-UM)

We analyse the effect of uncertainty concerning the state and the nature of asset price movements on the optimal monetary policy response. Uncertainty is modeled by adding Markov-switching shocks to a DSGE model with capital accumulation. In our analysis we consider both Taylor-type rules and optimal policy. Taylor rules have been shown to provide a good description of US monetary policy. Deviations from its implied interest rates have been associated with risks of financial disruptions. Whereas interest rates in Taylor-type rules respond to a small subset of information, optimal policy considers all state variables and shocks. Our results suggest that, when a bubble bursts, the Taylor rule fails to achieve a soft landing, contrary to the optimal policy.

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Paper provided by GEMF - Faculdade de Economia, Universidade de Coimbra in its series GEMF Working Papers with number 2008-02.

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Length: 37 pages
Date of creation: 2008
Date of revision:
Handle: RePEc:gmf:wpaper:2008-02
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