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The Optimality of the US and Euro Area Taylor Rule

  • Ferhat MIHOUBI
  • Pascal JACQUINOT

The purpose of this paper is to examine the optimality of the monetary authorities reaction function in the two-area medium size model MARCOS (US and euro areas). The parameters and the horizons of output gap and inflation expectations of the Taylor rule are computed in order to minimise a loss function of the monetary authorities. However, investigating the optimality of the Taylor rule in the context of a large scale macroeconomic model raises several difficulties: the model is non-linear and all the state variables potentially enter the optimal monetary policy rule. Furthermore, the optimality of the Taylor rule is assessed by the minimisation of the loss function under the constraint of a large forward-looking model. To overcome these problems, Black, Macklem and Rose [1998] propose a stochastic simulation based method which has been applied to single-country macroeconomic models. To study the optimality of the Taylor rule in the case of a two-area model, we suppose that the economy is stochastically hit by numerous shocks (supply, demand, monetary, exchange rate and world demand) in each area and simulate MARCOS stochastically.

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File URL: http://repec.org/sce2004/up.31791.1077901172.pdf
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Paper provided by Society for Computational Economics in its series Computing in Economics and Finance 2004 with number 220.

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Date of creation: 11 Aug 2004
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Handle: RePEc:sce:scecf4:220
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  1. Batini, Nicoletta & Nelson, Edward, 2000. "Optimal Horizons for Inflation Targeting," Working Paper Series 103, Sveriges Riksbank (Central Bank of Sweden).
  2. Andrew Levin & Volker Wieland & John C. Williams, 1998. "Robustness of simple monetary policy rules under model uncertainty," Finance and Economics Discussion Series 1998-45, Board of Governors of the Federal Reserve System (U.S.).
  3. Svensson, Lars E.O. & Rudebusch , Glenn, 1998. "Policy Rules for Inflation Targeting," Seminar Papers 637, Stockholm University, Institute for International Economic Studies.
  4. 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.
  5. Blanchard, Olivier Jean & Kahn, Charles M, 1980. "The Solution of Linear Difference Models under Rational Expectations," Econometrica, Econometric Society, vol. 48(5), pages 1305-11, July.
  6. Mark Gertler, 1997. "Government Debt and Social Security in a Life-Cycle Economy," NBER Working Papers 6000, National Bureau of Economic Research, Inc.
  7. Svensson, Lars E. O., 2000. "Open-economy inflation targeting," Journal of International Economics, Elsevier, vol. 50(1), pages 155-183, February.
  8. Steven A. Symansky & Douglas Laxton & Hamid Faruqee, 1996. "Government Debt, Life-Cycle Income and Liquidity Constrains; Beyond Approximate Ricardian Equivalence," IMF Working Papers 96/140, International Monetary Fund.
  9. Andrew G. Haldane & Nicoletta Batini, 1998. "Forward-Looking Rules for Monetary Policy," NBER Working Papers 6543, National Bureau of Economic Research, Inc.
  10. Aaron Drew & Benjamin Hunt, 1999. "Efficient simple policy rules and the implications of potential output uncertainty," Reserve Bank of New Zealand Discussion Paper Series G99/5, Reserve Bank of New Zealand.
  11. Hamid Faruqee & Douglas Laxton & Bart Turtelboom & Peter Isard & Eswar Prasad, 1998. "Multimod Mark III; The Core Dynamic and Steady State Model," IMF Occasional Papers 164, International Monetary Fund.
  12. Jacquinot, P. & Mihoubi, F., 2000. "Modele a anticipations rationnelles de la conjoncture simulee : MARCOS," Working papers 78, Banque de France.
  13. Aaron Drew & Ben Hunt, 1998. "The Forecasting and Policy System: stochastic simulations of the core model," Reserve Bank of New Zealand Discussion Paper Series G98/6, Reserve Bank of New Zealand.
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