Thuyết trình tài chính quốc tế Can central bank’s monetary policy be described by a linear (augmented) Taylor rule or by a monetary rule

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Can central bank’s monetary policy be
described by a linear (augmented) Taylor
rule or by a monetary rule?
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SUMMARY
Why study?
1
Literature reviews
4
Hypothesises and Prediction
3
Theories
2
Research methods
5
Conclusion
6
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Why study?
Should
central banks
obey a linear
(augmente)
Taylor rule or
nonlinear
rule? a

Need to
modeling to
test which
rule the
best is
How to
conduct
monetary
policy?
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STUDY OBJECTIVES
the roles of a
forward-
looking version
of the Taylor
rule in the
conduct of
monetary
policy
Objectives
The role of
asset prices
or financial
variables in
the conduct of
monetary
policy
Comparing a
linear Taylor

rule with a
nonlinear rule
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RESEARCH QUESTION

whether central banks’ monetary policy can
indeed be described by a linear Taylor rule
or, instead, by a nonlinear rule?

whether that rule can be augmented with a
financial conditions index containing
information from some asset prices and
financial variables?
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Theories
Taylor rule
Monetary
policy
Rational Expectation
Forward looking Taylor
rule
Asset prices vs Financial
variables
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Developing hypothesises

The relation between the interest rate,

inflation and the output gap is described
by A forward-looking Taylor Rule

The interest rate is not adjusted
immediately to its desired level but is
concerned about interest rate smoothing.

The central bank can have asymmetric
preferences that it might assign different
weights to expected negative and positive
inflation and output gaps in its loss
function
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Prediction

The central bank increases the real rate in
response to higher inflation, which exerts
a stabilizing effect on inflation; on the
other hand

In situations in which output is below its
potential a decrease in the interest rate
will have a stabilizing effect on the
economy.

The interest rate is adjusted to desired
rate gradually

The central banks’ monetary policy can

indeed be described better by a non-linear
Taylor rule
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INTRODUCTION

Taylor Rule (1993), of the linear alge- braic interest rate rule that
specifies how the Federal Reserve (Fed) of the United States (US)
adjusts its Federal Funds target rate to current inflation and output
gap.

Extension : Clarida et al. (1998,2000), who suggested the use of a
forward-looking version of the Taylor rule where central banks target
expected inflation and out- put gap instead of past or current values
of these variables
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INTRODUCTION

Important extension is related to the inclusion of asset prices and
financial variables in the rule.
ASSET PRICES ?
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INTRODUCTION
Estimate a linear Tay- lor rule for the
Eurozone, US and United Kingdom (UK)
augmented with a financial conditions
index that captures the relevant eco- nomic
information contained in some financial

variables
AIM OF
THIS
PAPER
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INTRODUCTION
A nonlinear model to the study of
the ECB’s monetary policy, where
the presence of asymmetries is
taken into account directly in the
structure of the mode
A nonlinear model to the study of
the ECB’s monetary policy, where
the presence of asymmetries is
taken into account directly in the
structure of the mode
The nonlinear specification of the
Taylor rule with the financial index
used in the linear estimations to
check whether, after controlling for
nonlinearities, the ECB and the
other two cen- tral banks are still
(or not) reacting to the information
contained in that index.
The nonlinear specification of the
Taylor rule with the financial index
used in the linear estimations to
check whether, after controlling for
nonlinearities, the ECB and the

other two cen- tral banks are still
(or not) reacting to the information
contained in that index.
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INTRODUCTION
13
The results also show that the ECB – contrary to the other central
banks – con- tinues to consider the information contained in the financial
index even after nonlinearities are controlled for
The ECB’s monetary policy is better described by a nonlinear monetary rule
than by a linear Taylor rule
1
2
The results of the estimation of the nonlinear smooth transi-
tion regression model
3
we find weak evidence to reject the linear model for the US but not
for the UK, where the BOE seems to be pursuing a target
range of 1.8–2.4% for inflation rather than the current official
point target of 2%.
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A BRIEF REVIEW OF LITERATURE
It is a monetary - policy rule that
stipulates how much the central
bank should change the nominal
interate rate in response to changes
ininflation, output, or other
economic conditions

TAYLOR
RULE
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A BRIEF REVIEW OF LITERATURE

Clarida et al. (1998,2000) suggest the use of a forward-looking
version of the Tay- lor rule where central banks target expected
inflation and output gap instead of past or current values of these
variables

Fourc¸ ans and Vranceanu (2004) and Sauer and Sturm (2007) also
stress the importance of considering a forward-looking Taylor rule in
the analysis of the ECB’s monetary policy
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A BRIEF REVIEW OF LITERATURE
Some studies extend this linear rule by considering the effect of other
variables in the conduct of monetary policy. EX :
16
Considering the role of money supply in the ECB reaction function,
Fendel and Frenkel (2006) and Surico (2007b) conclude that it does
not affect the ECB’s behaviour directly but it is a good instrument to
predict future inflation
Fourc¸ ans and Vranceanu (2004) present some evidence of an
ECB response to the exchange rate deviations from its average
1
2

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A BRIEF REVIEW OF LITERATURE
The role of asset prices is an important issue considered in some studies
Cecchetti et al. (2000), Borio
and Lowe (2002), Goodhart
and Hofmann (2002), Sack
and Rigobon (2003), Chadha
et al. (2004) and Rotondi and
Vaciago (2005) consider it
important that cen- tral banks
target asset prices
Bernanke and Gertler (1999,
2001) and Bullard and
Schaling (2002) do not agree
with an ex-ante control over
asset prices
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A BRIEF REVIEW OF LITERATURE
18
Kajuth (forthcoming) shows that monetary policy should also react to house
prices due to their effects on consumption
Driffill et al. (2006) analyse the interactions between monetary policy and the
futures market in the context of a linear reaction function

The issue of financial stability is also investigated by Montagnoli and Napolitano
(2005). They build and use a financial conditional indicator that includes the
exchange rate, share prices and house prices in the estimation of a Taylor rule for
some central banks
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A BRIEF REVIEW OF LITERATURE
19
Asymmetries in monetary policy can result from a nonlinear macroeconomic
model, ), nonlinear central bank preferences , or both .
The Taylor rule is consid- ered a simple linear interest rate rule that represents an
optimal policy-rule under the condition that the central bank is minimising a
symmetric quadratic loss function and that the aggregate supply function is linear

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A BRIEF REVIEW OF LITERATURE
20
The forward-looking nonlinear monetary policy rule used in our analysis takes into
account the asymmetries in the macroeconomic model and in the central bank
preferences implicitly and general- izes the Taylor rule in the tradition of Clarida
et al. (1998, 2000).
Surico (2007b) studies the presence of nonlinearities in the ECB monetary policy
for the period January 1999–December 2004 estimating a linear GMM model resulting
from the derivation of a loss function with asymmetric preferences and considering
a convex aggregate supply curve

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A BRIEF REVIEW OF LITERATURE
21
Petersen (2007) applies a simple logistic smooth transition regression model to the
monetary policy of the Fed over the period 1985–2005 using a basic Taylor rule
and finds the presence of nonlinearities: once inflation approaches a certain threshold,
the Fed begins to respond more forcefully to inflation

The appli- cation of nonlinear models to the analysis of Central Banks’ policy
behaviour: Martin and Milas (2004) and Petersen (2007). Martin and Milas (2004)
apply a nonlinear quadratic logistic smooth tran- sition model to the BOE’s monetary
policy.

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Research methods

Developing a forward-looking version
of theTaylor rule with assuming that
the central bank does not adjust the
interest rate immediately to its
desired level but is concerned about
interest rate smoothing

Including asset prices and financial
variables in the rule

Modeling the nonlinear Taylor rule
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Specification and estimation of the
linear Taylor rule

The linear Taylor rule

The forward-looking version of the
Taylor rule


The inclusion of interest rate
smoothing in the Taylor rule(*)
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
Inserting Eq. (3) into (2)
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Example: Moment Condition From RE

Consider a simple monetary policy rule, where the
interest rate depends on expected future inflation:

Noting that
(*)

where vt is the expectation error, we can write the
model as

Under rational expectations, the expectation error,
vt, should be orthogonal to the information set, It,
and for zt It we have the moment condition∈

This is enough to identify β