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

Fernando Alexandre (), Vasco J. Gabriel and Pedro Bação

No 15/2008, NIPE Working Papers from NIPE - Universidade do Minho

Abstract: We analyse the effect 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 financial 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.

Keywords: Asset Prices; Monetary Policy; Markov Switching. (search for similar items in EconPapers)
JEL-codes: E52 E58 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
Date: 2008
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Working Paper: Taylor-type rules versus optimal policy in a Markov-switching economy¤ (2008)
Working Paper: Taylor-type rules versus optimal policy in a Markov-switching economy (2008)
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