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Financial Market Conditions, Real Time, Nonlinearity and European Central Bank Monetary Policy: In-Sample and Out-of-Sample Assessment

  • Costas Milas

    ()

    ( Keele University, UK; The Rimini Centre for Economic Analysis (RCEA), Italy)

  • Ruthira Naraidoo

    ()

    ( University of Pretoria, South Africa)

We explore how the ECB sets interest rates in the context of policy reaction functions. Using both real-time and revised information, we consider linear and nonlinear policy functions in inflation, output and a measure of financial conditions. We find that amongst Taylor rule models, linear and nonlinear models are empirically indistinguishable within sample and that model specifications with real-time data provide the best description of in-sample ECB interest rate setting behavior. The 2007-2009 financial crisis witnesses a shift from inflation targeting to output stabilisation and a shift, from an asymmetric policy response to financial conditions at high inflation rates, to a more symmetric response irrespectively of the state of inflation. Finally, without imposing an a priori choice of parametric functional form, semiparametric models forecast out-of-sample better than linear and nonlinear Taylor rule models.

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File URL: http://www.rcfea.org/RePEc/pdf/wp42_09.pdf
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Paper provided by The Rimini Centre for Economic Analysis in its series Working Paper Series with number 42_09.

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Date of creation: Jan 2009
Date of revision: Jan 2009
Handle: RePEc:rim:rimwps:42_09
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