Nonlinearity and Structural Breaks in Monetary Policy Rules with Stock Prices

Dong Jin Lee () and Jong Chil Son
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Jong Chil Son: The Bank of Korea

No 2011-19, Working papers from University of Connecticut, Department of Economics

Abstract: This paper empirically examines how the Fed responds to stock prices and inflation movements, using the forward-looking Taylor rule augmented with the stock price gap. The typical linear policy reaction function has a substantial change after 1991, but lacks the robustness in that the estimation result is sensitive to a minor change of the sample period. To alleviate the problem, we allow for temporary and permanent variations of the reaction coefficients by introducing nonlinearity and a structural break. The time variation of the inflation coefficient shows that the Fed is more aggressive in periods of inflationary pressure. However, unlike the linear model case, we find little evidence of a significant change in the Fed's active response to inflationary pressure after the structural break at 1991:I. We also find a positive response to the stock price change after 1991:I. But the time varying pattern of the response is counter-cyclical to stock price change, which does not support the view that the Fed actively reacts to a stock price bubble.

Keywords: Monetary policy rule; nonlinear model; stock market; structural break; and time varying coefficient (search for similar items in EconPapers)
JEL-codes: E31 E44 E52 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
Date: 2011-10
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Persistent link: http://EconPapers.repec.org/RePEc:uct:uconnp:2011-19

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