2. Topics in Monetary Policy: The Taylor Rule

Question 1

What is a Taylor rule?

Answer 1

An MP rule that stipulates how much the central bank should change the nominal interest rate in response to changes in inflation, output or other economic conditions

Question 2

How is it thought that the Central Bank has an effect on the economy?

Answer 2

The interest rate that the CB sets for loans to smaller banks is thought to have an effect across the entire economy

Question 3

What is the problem that the Central Bank faces with controlling the money supply (M)?

Answer 3

It is very difficult to control, as it gets lost or removed from the economy.

Question 4

Give the formal expression for the Taylor rule

Answer 4

i(t)= r[n]+γ(π)(π(t)-π*)+γ(Y)(y(t)-y[n])

Note: ( ) = subscript, [ ] = superscript

r[n] = natural interest rate
y[n] = natural level of output

γ(Y) and γ(π) are parameters

Question 5

What does the expression for the Taylor rule say?

Answer 5

The nominal interest rate is roughly equal to the natural interest rate + the difference between current and target inflation + the difference between current and natural output

Question 6

What values of γ(Y) and γ(π) does Taylor propose? Why?

Answer 6

γ(π) = 1.5
γ(Y) = 0.5

It is not clear why

Question 7

What variables used in the TR are easy to find out?

Answer 7

Current levels of inflation and output

However it is not certain what best measure of inflation is

Question 8

What variables used in TR are hard to work out?

Answer 8

The natural levels of the interest rate and output

Question 9

How can the natural level of output be calculated?

How can the difference between natural and current levels of output be calculated?

Answer 9

A line can be fitted to its trend over time

Compare the estimated trend line with the current level

Question 10

How can discrepancies in the calculated difference between natural and current levels of output come about?

(two things)

Answer 10

The predicted natural level depends on how far back the trend line is estimated from

The line may be estimated as quadratic, polynomial etc. which would each give different figures

Question 11

What does a yield curve show?

Answer 11

The relationship between the interest rate and the time to maturity (amount on time before the loan must be repaid)

Question 12

In terms of the mapping of interest rates (yield) by their time to maturity, what does evidence show regarding the effect of the CB on the rest of the economy?

(3 points)

Answer 12

As CBs only trade in short term loans, it only directly changes interest rates for those loans (low yield curves)

It is evident that changes to these interest rates affect interest rates for longer-term loans

Therefore it seems that the CB does have an effect on the rest of the economy

Question 13

What is a yield?

Answer 13

The income return on an investment

Question 14

Is the manner in which the CBs actions affect the economy clear?

What leads you to this conclusion??

Answer 14

No

If you look at the yield curves for loans with different times to maturity, it is evident that the difference between interest rates for long term vs short term loans is not constant over time - it cannot be that a 3 month loan has the same yield as three 1 month loans

Question 15

Give 2 benefits of the Taylor rule

Answer 15

• It is easy to understand. Good for communication with the public
• It is a useful benchmark for policy makers. If inflation/output is off-target then the TR provides some direction as to what should be done

Question 16

Give 5 cons for the Taylor Rule

Answer 16

• Doesn’t account for the zero lower bound
• It is unclear what inflation measure should be used
• It difficult to obtain measures for the output gap and real interest rates
• It leaves out lots of variables that the CB might use (e.g. labour market and financial variables / international effects)
• It is linear. Doesn’t reflect whether the nominal interest rate is too low/high. Also, what happens if i(t) should be zero?

Question 17

What paper developed an expansion of the Taylor rule?

Answer 17

Clarida, Gali & Gertler (2000)

Question 18

In the expanded version of the TR, what do interest rates depend on?

Answer 18

• The past interest rate
• Target Inflation
• EXPECTED inflation
• The EXPECTED output gap

Question 19

Give the formula for the expanded Taylor rule

Answer 19

i(t) = ρi(t−1) + b(E[π(t+1)] − π∗) + c(E[y(t+1) − yn])

Question 20

Why to Clarida, Gali & Gertler (2000) use expectations in their expansion of the TR?

Answer 20

The wanted to control for econometric issues that they faced in the data

Question 21

What are the issues with the expanded TR?

2 points

Answer 21

• We don’t observe the expected level of inflation E[π(t+1)] or the expected output gap E[y(t+1) − yn]
• Hence a ‘best predictor’ must be created

Question 22

What were the 2 periods that the Clarida, Gali and Gertler (2000) separately estimated a model for?

Answer 22

Pre-Volcker (1960 - 1979)

Volcker-Greenspan (1979 - 1996)

Question 23

What were the findings of the Clarida, Gali and Gertler paper?

(2 points)

Answer 23

• Target inflation decreased over the 2 periods (suggests that Volcker was more worried about inflation)
• Policy became more responsive to deviations way from target inflation / output

Question 24

What does Taylor claim about the recession?

2 points

Answer 24

• It was man made

- It was because MP was too lax between 2003 and 2008 (the interest rate should have been higher according to his rule)

Question 25

What is the Taylor principle?

2 points

Answer 25

Says that the nominal interest rate must increase by more than 1:1 with inflation in order to push inflation back to its target

I.e. γπ must be >1 in order to stabilise the economy

Question 26

What is the point of a MP rule?

Answer 26

To stabilise the economy in the event that output or inflation deviate from their target levels