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

We analyse the effect of uncertainty concerning the state and the nature of asset price movements on the optimal monetary policy response. Uncertainty is modelled 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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File URL: http://www3.eeg.uminho.pt/economia/nipe/docs/2008/NIPE_WP_15_2008.PDF
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Paper provided by NIPE - Universidade do Minho in its series NIPE Working Papers with number 15/2008.

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Date of creation: 2008
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Handle: RePEc:nip:nipewp:15/2008
Contact details of provider: Postal: Núcleo de Investigação em Políticas Económicas, Escola de Economia e Gestão, Universidade do Minho, P-4710-057 Braga, Portugal
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  2. Svensson, Lars E.O. & Rudebusch , Glenn, 1998. "Policy Rules for Inflation Targeting," Seminar Papers 637, Stockholm University, Institute for International Economic Studies.
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  4. Lars E.O. Svensson, 2002. "What Is Wrong with Taylor Rules? Using Judgment in Monetary Policy through Targeting Rules," Working Papers 118, Princeton University, Department of Economics, Center for Economic Policy Studies..
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  15. Fernando Alexandre & Pedro Bação & John Driffill, 2007. "Optimal monetary policy with a regime-switching exchange rate in a forward-looking model," GEMF Working Papers 2007-09, GEMF - Faculdade de Economia, Universidade de Coimbra.
  16. Glenn D. Rudebusch, 2005. "Monetary policy inertia: fact or fiction?," Working Paper Series 2005-19, Federal Reserve Bank of San Francisco.
  17. Stephen G. Cecchetti & Anil K Kashyap, 1995. "International Cycles," NBER Working Papers 5310, National Bureau of Economic Research, Inc.
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  19. Michael Woodford, 2007. "Forecast Targeting as a Monetary Policy Strategy: Policy Rules in Practice," NBER Working Papers 13716, National Bureau of Economic Research, Inc.
  20. Driffill, John & Sola, Martin, 1998. "Intrinsic bubbles and regime-switching," Journal of Monetary Economics, Elsevier, vol. 42(2), pages 357-373, July.
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