Are Central Banks following a linear or nonlinear (augmented) Taylor rule?

Vitor Castro

No 269883, Economic Research Papers from University of Warwick - Department of Economics

Abstract: The Taylor rule establishes a simple linear relation between the interest rate, inflation and output gap. However, this relation may not be so simple. To get a deeper understanding of central banks’ behaviour, this paper asks whether central banks are indeed following a linear Taylor rule or, instead, a nonlinear rule. At the same time, it also analyses whether that rule can be augmented with a financial conditions index containing information from some asset prices and financial variables. A forwardlooking monetary policy reaction function is employed in the estimation of the linear and nonlinear models. A smooth transition model is used to estimate the nonlinear rule. The results indicate that the European Central Bank and the Bank of England tend to follow a nonlinear Taylor rule, but not the Federal Reserve of the United States. In particular, those two central banks tend to react to inflation only when inflation is above or outside their targets. Moreover, our evidence suggests that the European Central Bank is targeting financial conditions, contrary to the other two central banks. This lack of attention to the financial conditions might have made the United States and the United Kingdom more vulnerable to the recent credit crunch than the Eurozone.

Keywords: Financial Economics; Research Methods/ Statistical Methods (search for similar items in EconPapers)
Pages: 45
Date: 2008-09-09
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (36)

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Working Paper: Are Central Banks following a linear or nonlinear (augmented) Taylor rule? (2008)
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Persistent link: https://EconPapers.repec.org/RePEc:ags:uwarer:269883

DOI: 10.22004/ag.econ.269883

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