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Questioning The Taylor Rule

Rodrigo De-Losso

No 2012_22, Working Papers, Department of Economics from University of São Paulo (FEA-USP)

Abstract: This article estimates a forward-looking Taylor-rule-type reaction function exclusively during Greenspan’s tenure and shows a considerable loss in both magnitude and significance of the inflation coefficient compared with the extended sample that otherwise includes Volcker’s tenure. That fact indicates that the interest rate pushing up in the early 1980s drives the coefficient towards being greater than one, when in fact it varies. A key variable in determining its size is the output gap, which is unobservable. Therefore, the paper approaches the Kalman filter to estimate the Taylor rule reaction function jointly with output gap, in order to characterize the monetary policy in the U.S. from 1960 to 2005. The results show that the point estimation of inflation is overall smaller than one-toone when the sample is split into either before and after Volcker’s appointment as Federal Reserve chairman or before and after Greenspan’s tenure. When the model allows for a drifting inflation coefficient, then the estimate is barely greater than one and often negative. Such a dynamics matches up with Greenspan’s claim that monetary policy is discretionary and that the Federal Reserve does not follow any simple rule. Consequently, an inflation coefficient inferior to one may be associated with monetary stability, disrupting the Taylor’s principle.

Keywords: Taylor rule; Kalman Filter; Hidden variables; GMM (search for similar items in EconPapers)
JEL-codes: C32 C51 E52 (search for similar items in EconPapers)
Date: 2012-09-17
New Economics Papers: this item is included in nep-mac and nep-mon
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