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Nonlinear Interest Rate Reaction Functions for the UK

  • Ralf Brüggemann

    ()

    (Department of Economics, University of Konstanz, Germany)

  • Jana Riedel

    ()

    (Wirtschaftswissenschaftliche Fakultät, Westfälische Wilhelms-Universität Münster, Germany)

We empirically analyze Taylor-type equations for short-term interest rates in the United Kingdom using quarterly data from 1970Q1 to 2006Q2. Starting from strong evidence against a simple linear Taylor rule, we model nonlinearities using logistic smooth transition regression (LSTR) models. The LSTR models with time-varying parameters consistently track actual interest rate movements better than a linear model with constant parameters. Our preferred LSTR model uses lagged interest rates as a transition variable and suggests that in times of recessions the Bank of England puts more weight on the output gap and less so on inflation. A reverse pattern is observed in non-recession periods. Parameters of the model change less frequently after 1992, when an inflation target range was announced. We conclude that for the analysis of historical monetary policy, the LSTR approach is a viable alternative to linear reaction functions.

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Paper provided by Department of Economics, University of Konstanz in its series Working Paper Series of the Department of Economics, University of Konstanz with number 2010-15.

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Length: 24 pages
Date of creation: 03 Dec 2010
Date of revision:
Handle: RePEc:knz:dpteco:1015
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  1. M Kesriyeli & D R Osborn & M Sensier, 2004. "Nonlinearity and Structural Change in Interest Rate Reaction Functions for the US, UK and Germany," Centre for Growth and Business Cycle Research Discussion Paper Series 44, Economics, The Univeristy of Manchester.
  2. Richard Clarida & Jordi Gali & Mark Gertler, 1997. "Monetary Policy Rules in Practice: Some International Evidence," NBER Working Papers 6254, National Bureau of Economic Research, Inc.
  3. Gerlach-Kristen, Petra, 2003. "Interest rate reaction functions and the Taylor rule in the euro area," Working Paper Series 0258, European Central Bank.
  4. Castro, Vítor, 2008. "Are Central Banks following a linear or nonlinear (augmented) Taylor rule?," The Warwick Economics Research Paper Series (TWERPS) 872, University of Warwick, Department of Economics.
  5. J. J. Dolado & R. Maria-Dolores & F. J. Ruge-Murcia, 2002. "Nonlinear Monetary Policy Rules: Some New Evidence For The Us," Economics Working Papers we022910, Universidad Carlos III, Departamento de Economía.
  6. Clarida, R. & Gali, J. & Gertler, M., 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Working Papers 99-13, C.V. Starr Center for Applied Economics, New York University.
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  8. Qin, Ting & Enders, Walter, 2008. "In-sample and out-of-sample properties of linear and nonlinear Taylor rules," Journal of Macroeconomics, Elsevier, vol. 30(1), pages 428-443, March.
  9. Krolzig, H.-M. & Toro, J., 2001. "Classical And Modern Business Cycle Measurement: The European Case," Economics Series Working Papers 9960, University of Oxford, Department of Economics.
  10. Paolo Surico, 2004. "Inflation Targeting and Nonlinear Policy Rules: the Case of Asymmetric Preferences," Econometric Society 2004 Latin American Meetings 8, Econometric Society.
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  12. Assenmacher-Wesche, Katrin, 2006. "Estimating Central Banks' preferences from a time-varying empirical reaction function," European Economic Review, Elsevier, vol. 50(8), pages 1951-1974, November.
  13. Gerlach, Stefan & Schnabel, Gert, 2000. "The Taylor rule and interest rates in the EMU area," Economics Letters, Elsevier, vol. 67(2), pages 165-171, May.
  14. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
  15. Paolo Surico, 2003. "Asymmetric Reaction Functions for the Euro Area," Oxford Review of Economic Policy, Oxford University Press, vol. 19(1), pages 44-57.
  16. Dieter Gerdesmeier & Barbara Roffia, 2004. "Empirical Estimates of Reaction Functions for the Euro Area," Swiss Journal of Economics and Statistics (SJES), Swiss Society of Economics and Statistics (SSES), vol. 140(I), pages 37-66, March.
  17. Cukierman Alex & Muscatelli Anton, 2008. "Nonlinear Taylor Rules and Asymmetric Preferences in Central Banking: Evidence from the United Kingdom and the United States," The B.E. Journal of Macroeconomics, De Gruyter, vol. 8(1), pages 1-31, February.
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