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Generalizing the Taylor Principle

  • Troy Davig


    (Federal Reserve Bank of Kansas City)

  • Eric M. Leeper


    (Indiana University Bloomington)

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 evolve according to a Markov process. We derive a long-run Taylor principle that 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 Taylorprinciple 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.

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Paper provided by Center for Applied Economics and Policy Research, Economics Department, Indiana University Bloomington in its series Caepr Working Papers with number 2006-001.

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Length: 44 pages
Date of creation: Aug 2006
Date of revision:
Handle: RePEc:inu:caeprp:2006001
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