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

  • Fernando Alexandre

    (University of Minho)

  • Pedro Bação

    (University of Coimbra)

  • Vasco Gabriel

    (University of Surrey)

We analyse the e®ect 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 ¯nancial 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://www.fahs.surrey.ac.uk/economics/discussion_papers/2008/DP06-08.pdf
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Paper provided by School of Economics, University of Surrey in its series School of Economics Discussion Papers with number 0608.

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Length: 31 pages
Date of creation: Jun 2008
Date of revision:
Handle: RePEc:sur:surrec:0608
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