Taylor Rule and Financial Instability

Gianfranco Zampese

No 1757, BAFFI CAREFIN Working Papers from BAFFI CAREFIN, Centre for Applied Research on International Markets Banking Finance and Regulation, Universita' Bocconi, Milano, Italy

Abstract: This paper estimates an augmented/non-linear Taylor rule for the ECB and the Riksbank to include financial instability factors. The existence of nonlinearities will be explored and assessed through the estimation of a threshold regression model. The threshold model divides the sample in two distinct subsamples, each representative of a different regime. A composite indicator of systemic stress characterizes the two regimes into a low instability regime and a high instability regime. The results are quite clear. They show us that the classical Taylor rule performs well during Regime 1, or “normal administration times"; but it shows inherently weaknesses in describing the behavior of CBs during financial instability periods, when discretion may be necessary. Remarkably such a non-linear model is also successful in not crossing the ZLB.

Pages: 70 pages
Date: 2017
New Economics Papers: this item is included in nep-mon
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