Explain carefully the rationale for the Taylor rule in monetary policy and discuss the extent to which modern central banks in major countries have been following Taylor rules.
According to Goodhart’s speech in 1998, the key decision that the monetary authorities take each month is whether, and by how much, to alter the short- term interest rate. As central banks vary interest rates in response to economic development the crucial question has become how they should adjust it in order to achieve, or to come as close as possible to, the social welfare optimum. The vital importance of this decision for the financial community and therefore the economies in general could be observed in the public discussion which frequently occurs about how the Fed and the ECB should react by changing the short term interest rates.
A popular way of explaining the way central banks take its interest rate decisions has been proposed by Taylor in 1993. He basically suggested a rule, which he derived from observation of former successful monetary policy. This essay shows how the Taylor rule works and to which extent major central banks have been following the rule.
The first chapter of this essay briefly explains the rationale and advantages of simple monetary policy rules. The second chapter focuses on the Taylor rule itself and explains the way it works by referring to the preceding chapter.
Finally the last chapter discusses the work of the central banks in the last decades.
2. Why do we need Simple Monetary Policy Rules?
In 1990 Taylor started promoting the use of simple monetary policy rules in the setting of interest rates by the Fed. He pointed out several advantages, which their use would provide. The consideration of his argumentation helps to understand the notions and the complex mechanisms behind his famous rule. Therefore the next chapter focuses on these basic ideas from which the rule originated.
2.1 Economic Principles
Taylor took five economic principles as a starting- point for his work (see Taylor 1998). He assumed that there was a general consensus about these “key macroeconomic principles”. From the following principles he derived implications and recommendations for monetary policy.
i) The long-term trend of real GDP is well described by modern neoclassical growth theory, with the growth rate of productivity depending on capital per hour of work and on technology.
ii) There is no long-run trade-off between inflation and unemployment.
iii) There is a short run trade-off between inflation and unemployment, which implies that changes in monetary policy have short-run impact on unemployment even though monetary policy is neutral in the long-run.
iv) People’s expectations of the future are of vital importance for the evaluation of monetary policy. Furthermore these expectations are endogenous to policy changes.
v) The four preceding principles lead to the last one: monetary authorities should select a target inflation rate and the instruments of policy should ensure that inflation would stay next to the target.
He further states that a low inflation target is to be preferred to a higher one and that there is no need for a long-run target for the unemployment rate due to the inability of monetary policy to influence the unemployment in the long-run. Furthermore he argued that simply opting for a target inflation is not enough due the existence of shocks cause the economy to move away from the target. Consequently there is a need for guidelines of how to change/use the instruments of monetary policy in order to response correctly to these shocks. These guidelines can be provided by a policy rule.
2.2 Advantages of Simple Monetary Policy Rules
Taylor also brought forward several other reasons why simple monetary policy rules can increase the performance of the work of monetary authorities (Taylor 1998). They can contribute to limit the time inconsistency problem by reducing the chance that the monetary policymakers would change their policy after people in the private sector have taken their actions. The use of simple rules could also provide clearer explanations for the public, which in return means a better educated public and more effective democracy. Furthermore, they help to reduce short-run political pressure and uncertainty by describing future policy actions more clearly.
All these reasons help to comprehend why central banks, which have been acting according to the Taylor rule, could contribute to a more stable economic environment and less inflationary pressure. This list of advantages also gives a good idea of how the Taylor rule works in practice.
3. The Taylor rule
In 1993 Taylor proposed a simple rule, which was both descriptive and prescriptive:
illustration not visible in this excerpt
The funds rate is it . The constant term, 2, is the assumed long-run average of the real rate of interest. The prior four- quarter inflation rate is pt and the FOMC’s inflation target is [illustration not visible in this excerpt]. The output gap, xt, is the percentage deviation of real GDP from a trend line measuring potential output. Taylor assumes that the FOMC’s inflation target has remained unchanged at 2 percent. (Hetzel 2000, Taylor 1998)
- Quote paper
- Dipl. Kfm. Kristian Kanthak (Author), 2002, Explain carefully the rationale for the Taylor rule in monetary policy and discuss the extent to which modern central banks in major countries have been following Taylor rules, Munich, GRIN Verlag, https://www.grin.com/document/10100