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Interest Rate Smoothing versus Serially Correlated Errors in Taylor Rules: Testing the Tests


  • Welz, Peter

    () (Department of Economics)

  • Österholm, Pär

    () (Department of Economics)


This paper contributes to the recent debate about the estimated high partial adjustment coefficient in dynamic Taylor rules, commonly interpreted as deliberate interest rate smoothing on the part of the monetary authority. We argue that a high coefficient on the lagged interest rate term may be a consequence of an incorrectly specified central bank reaction function. Focusing on omitted variables, our Monte Carlo study first generates the well-known fact that all coefficients in the misspecified equation are biased in such cases. In particular, if relevant variables are left out from the estimated equation, a high partial adjustment coefficient is obtained even when it is in fact zero in the data generating process. Misspecification also leads to considerable size distortions in two tests that were recently proposed by English, Nelson, and Sack (2003) in order to distinguish between interest rate smoothing and serially correlated disturbances. Our results question the common interpretation of very slow partial adjustment as interest rate smoothing in estimated dynamic Taylor rules.

Suggested Citation

  • 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.
  • Handle: RePEc:hhs:uunewp:2005_014

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    References listed on IDEAS

    1. 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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    Cited by:

    1. Cinzia Alcidi , Alessandro Flamini, Andrea Fracasso, 2005. ""Taylored rules". Does one fit (or hide) all?," IHEID Working Papers 04-2005, Economics Section, The Graduate Institute of International Studies, revised Apr 2006.
    2. Jie Chen, 2006. "The Dynamics of Housing Allowance Claims in Sweden: A Discrete Time-Hazard Analysis," European Journal of Housing Policy, Taylor and Francis Journals, vol. 6(1), pages 1-29, April.
    3. Hallberg, Daniel, 2006. "Cross-national differences in income poverty among Europe´s 50+," Working Paper Series 2006:14, Uppsala University, Department of Economics.
    4. Johansson, Fredrik & Klevmarken, Anders, 2006. "Explaining the size and nature of response in a survey on health status and economic standard," Working Paper Series 2006:2, Uppsala University, Department of Economics.
    5. Eleftheriou, Maria, 2009. "Monetary policy in Germany: A cointegration analysis on the relevance of interest rate rules," Economic Modelling, Elsevier, vol. 26(5), pages 946-960, September.
    6. Berg, Lennart & Berger, Tommy, 2005. "The Q theory and the Swedish housing market –an empirical test," Working Paper Series 2005:19, Uppsala University, Department of Economics.
    7. Qiong Li & Zhiwei Wang, 2010. "The Taylor rules and macroeconomic fluctuation in China: 1994–2006," Frontiers of Economics in China, Springer;Higher Education Press, vol. 5(2), pages 232-253, June.
    8. Travaglini, Guido, 2007. "The U.S. Dynamic Taylor Rule With Multiple Breaks, 1984-2001," MPRA Paper 3419, University Library of Munich, Germany, revised 15 Jun 2007.
    9. Gerberding, Christina & Seitz, Franz & Worms, Andreas, 2007. "Money-based interest rate rules: lessons from German data," Discussion Paper Series 1: Economic Studies 2007,06, Deutsche Bundesbank.

    More about this item


    Monetary policy; Taylor rule; Interest rate smoothing; Serially correlated error term; Omitted variables;

    JEL classification:

    • C12 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Hypothesis Testing: General
    • C15 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Statistical Simulation Methods: General
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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