Taylor Rule

Question 1

Define Old Monetarism

Answer 1

Using a money aggregate to influence the price level and inflation

Question 2

What changed in Fed policy in 1983

Answer 2

Fed started ignoring money demand and supply as ways of controlling inflation, instead looking to the target nominal interest rate.

Question 3

Define New Monetarism

Answer 3

Using a nominal interest rate to influence inflation and the price level.

If the nom. interest rate exceeds the current real interest rate + expected inflation, then md will exceed M/P, causing a rise in real interest rates and a corresponding fall in inflation. Vice-versa for the opposite case.

Question 4

Significance of using the nominal interest rate to control inflation?

Answer 4

Feedback through inflation:
Too high a nominal interest rate would cause increased inflation
Too low a nom. interest rate would cause decreased inflation
Therefore, some indication is given of where the equilibrium nominal interest rate is currently at.

Question 5

How can the Fed establish a fixed real interest rate via a specific nominal interest rate?

Answer 5

Via a fixed nom. interest rate + what the Fed thinks to be expected inflation based on past inflation. Since i= pi + r, a fixed i and a number for pi corresponds to a fixed real interest rate. Inflation is still a problem though.

Question 6

How is the real interest rate controlled through the use of a target nominal interest rates in the presence of strong inflation-feedback?

Answer 6

i = r* + pi + a(pi-pi* )

Question 7

What happens to nominal interest rates if a is large?

Answer 7

Corresponds to high reactivity to inflation, which causes instability in the nominal interest rate (short term interest rates) but means that inflation remains relatively stable.

Question 8

State the Taylor Rule

Answer 8

i*	=	r*	+	π	+	a(π	–	π*)	+	b	ygap,		where:
r* = Fed's best guess of the equilibrium real interest rate, which is currently around 2%
a = inflation feedback coefficient
ygap = deviation of output from trendline	

Named for John Taylor in 1995
1987-1992: Fed followed rule for Fed Funds target i*

Question 9

What is ygap, and what does it indicate?

Answer 9

Deviations from the output trendline (if output exceeds the trendline, ygap is positive). When ygap is positive, unemployment is usually low.

Question 10

Findings of the study by Clarida, Gali and Gertler?

Answer 10

Found that although the taylor rule was used from 1959-1978, a was only at 0.6, meaning that the Fed was allowing inflation to accelerate due to weak inflation feedback (hence the double digit inflation of the 1980s)

For the period from 1979 onwards, however, a reached 2, meaning that the Fed had switched to a strong inflation feedback taylor rule, which explains why inflation was brought back under control. (achieved through high nominal interest rates and a constraint on money growth)

Question 11

Finds of the study by Nelson and Plosser (1982)?

Answer 11

That ygap is a statistical illusion due to its random walk nature. Suggests that Ugap, which is deemed a more meaningful measure, instead be introduced into the Taylor Rule as -0.25Ugap in place of the 0.5 ygap term.

Ugap term is negative to reflect the need for a decrease in nominal interest rates in the event of higher unemployment.

Question 12

Why should the Fed target a positive inflation rate? (around 2%?)

Answer 12

To provide room for lower nominal interest rates without causing real rates to go below 0 in the event of deflation

Question 13

How is the nominal interest rate set in the case of no inflation feedback?

Answer 13

i* is fixed at a certain level, and does not change in response to changes in r or pi.

Problems with no inflation feedback:
A fixed i* implies that for every change in pi, there must be a corresponding change in r. An i*> r0 + pi(e) would signify that r>r0, corresponding to decelerating inflation, which, according to the fisher equation, would cause an even higher r. Thus, a nominal interest rate that does not respond to inflation would cause either an inflationary or deflationary spiral)

Result: instability for both r and pi.
(unless i* is exactly equal to inflation expectations + the equilibrium real interest rate)

Question 14

How is the nom. interest rate determined in the case of 100% inflation - feedback?

Answer 14

The nominal interest rate is changed one-for-one for changes in inflation. The real interest rate, however, is fixed at r*, calculated using present i - anticipated inflation.

Problems with 100% inflation feedback:
A fixed r* with a variable i would nevertheless correspond to either accelerating, or decelerating inflation, since r* may not necessarily be = to r0 - may be too high or too low. For instance, if r* is too low, inflation would accelerate.

Result: instability for i and pi.

Question 15

How is the nom. interest rate determined in the case of strong inflation feedback?

Answer 15

i= r + π + a(π-π), where a is i’s sensitivity to π’s deviations from π. π* is the Fed inflation target.
Implies that i=(r -aπ) + (1+a)π. Since a>0, (1+a)>100%. If π increases, then r also increases via an even larger increase in i, so eventually, md> (M/P), and π decreases.

Question 16

Recall the equation that expresses i* when π=πe.

Answer 16

When π=πe, i= r0 + π= r + π + a(π-π), which means that π= π + (r0-r)/a.
What this means is that for π=π, r* must be at equilibrium level.
For larger values of a, it is implied that π is nearer to π, but that i is far more sensitive to deviations in π from π*.

Question 17

Recall the 0ygap version of the Taylor Rule

Answer 17

i= 1 + 1.5π = (r-aπ) + (1+a)π.
Since 1+a = 1.5, a=0.5
r-aπ* = 1

Question 18

Recall the “Benchmark” Taylor Rule

Answer 18

i* = 1 +1.5π + 0.5ygap
At equilibrium, ygap = 0.
Yardstick for the Fed Funds target rate

Question 19

Define the zero lower bound problem

Answer 19

If i=0, and if -r0>πe (assuming πe remains positive), then r>r0. Since i=0, the excess D for M that is created may cause inflation to decrease even more.
Therefore, π* = 2%.