Why are Taylor rules attractive to central bank1 Essay

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Why are Taylor rules attractive to central banks? Are these rules optimal?

Policy actions affect the economy with a lag
Private information causes expectations to be formed with previous period information or estimates
Even policy makers have imperfect information
Lags and uncertainties cause difficulties in policy
Friedman: k% rule – steady growth and forget stabalisation
For stabalisation:
Stocks earn greater return than bonds due to moderate risk in stocks – SR variability costs could be large (kandel pg 524)
Not just stable consumption – stable work hours – labour supply relatively inelastic, utility in hours worked will be far more curved. Allows a more clear analysis of utility offsets in boom and bust periods
Invetment of all types promoted
Implausible? Consider micro sourcing considerations for firms and the actual effect of uncertainty is unclear and there is a large range of responses for all firms
Benefits through non-linearities in supply (525)

CB conducts policy by adjusting ST nominal IR in response to disturbance
Why adjust? Shocks cause inflation > inflation changes the real interest rate (nominal fixed) > further unsubstantiated changes in output > further inflation effects (Friedman 1968)
Taylor: 2 elements: more than one for one
Real IR increases when Inflation rises
IR changes with output – negative feedback system
Linear in inflation
Ir should depart from LT equilibrium when inflation above target and output above natural rate
B (inf) c(y) = 0.5 with inflation target = 2%

Rules presume (reputation) CB can set IR according to a rule without a binding commitment even if the rule is not dynamically consistent.
Values of coefficients? Large coeffecients can cause a rapid return but possible overshooting and also SR volatility. How to measure inflation? Natural rate of output determination (527 Staiger – unemployment interval at least 2% wide with 95% significance). Difficulty in telling whether output is above or below. Orphanides applied taylor rules to 1970s and they fit – inflation was due to overestimates of natural output Should they be forward looking? – good but less robust to errors Additional variables – lagged IR and exchange rate

Inflation targeting
Explicit target
Place weight on inflation
Emphasis on transparency of methods and accountability for policy

Conservative window dressing – emphasis on behaviour of inflation and a clear lower target than in previous years. Focus on the inflation rather than the tools to achieve targeting.

Inflation targeting matters – credibility, transparency and accountability. Effects on expected inflation (output does not need to suffer) – see 10.5. anchoring also dampens the effects of disturbnances. Not a large effect on average output.

Transparency reduces uncertainty and accountability improves incentives.
See 28. 533

Svensson and Ball have an optimal taylor rule model with lags. Changes in real IR affect the next period (y) and the period after for inflation
Disturbances to both demand and supply.

Negatively depends on real IR from the last period
Positively depends on output from the last period (lagged)
A disturbance

Depend on prices and output in the last period

CB chooses after disturbances to demand and supply – wants to keep natural y and inflation = 0 for simplicity
Changes in rt impact y in the next period only. Only through yt is inflation affected.

Optimal policy
R only affects y in the next period
Y becomes a function of inflation for the next period (for the optimal policy)
Optimal policy is the expectations of y=inflation in the next period.
Must minimise loss function.
As optimal lambda rises (CB places more weight on inflation stability), q rises as it induces a department from natural output
Type of inflation targeting – rule for the expected behaviour of inflation
Inflation in next period is beyond control – policy tries to bring it to normalised level
Not optimal since there are restrictions on