Can central bank’s monetary policy be described by a linear (augmented) Taylor rule or by a nonlinear rule? BỘ MÔN TÀI CHÍNH QUỐC TẾ GS.TS Trần Ngọc Thơ GĐ A201 (E303) 23 Số 4 Danh sách nhóm 1. Nguyễn Thị Ngọc Cẩm 3. Vũ Quỳnh Hoa 2. Đoàn Thị Thanh Thủy 4. Tạ Quang Vũ GVHD: Lớp: Khóa: Paper: Vítor Castro (2011) 1 • Inroduction 2 • Literature review 3 • The linear Taylor rule 4 • The nonlinear Taylor rule 5 • Conclusions CONTENT Nonlinear rule Augmented with a financial conditions index Forward-looking version The original Taylor Rule • Is Central Banks reacting differently to levels of inflation/ output gap above and below the target • Central banks target expected Inflation and output gap instead of past or current value • Simple linear relation beween Interest Rate, Inflation and The Output Gap ASTRACT • Asset prices • Financial variables CONTENT OF PAPER ASTRACT The monetary behaviour of the European Central Bank (ECB) and Bank of England (EOB) is best descibed by a nonlinear rule The behaviour of the Federal Reserve of the United States (FED) can be well descibed by a linear Taylor rule Only ECB is reacting to financial conditions RESULT OF PAPER • Purpose of paper • Methodology and data • Paper’s meaning 1. INTRODUCTION • THE ORIGINAL TAYLOR RULE 1. INTRODUCTION The original Taylor rule establishes a simple linear relation beween Interest Rate, Inflation and The Output Gap PURPOSE OF THE PAPER • THE ORIGINAL TAYLOR RULE • The nominal short-term interest rate – the monetary policy instrument • Equilibrium real rate • Inflation at t • Target Inflation • Output gap at t • Potential output gap • 1. INTRODUCTION PURPOSE OF THE PAPER 1. INTRODUCTION PURPOSE OF THE PAPER Extension 1: Forward-looking version • Use expected Inflation and Output gap instead of past or current value Extension 2: Augmented with a financial conditions index • Central Bank are targeting the revelant economic information contained in a group of financial variables 1st PURPOSE Estimate a linear Taylor rule for the Eurozone, US and UK Augmented with a financial conditions index capture asset proces and financial variables The weight of each asset and financial variable is allowed to vary over the time 1. INTRODUCTION PURPOSE OF THE PAPER Extension 3: Consider nonlinearities in the analyst of monetary policy • The central bank might assign different weights to expected negative and possitive inflation and output gap in its loss function 1. INTRODUCTION PURPOSE OF THE PAPER [...]... the asymmetric in the macroeconomic model and in the central bank preferences implicitly and generalizes in Taylor rule in the traditional of Clarida el al., (1998, 2000) The asymmetric are accounted for by a separate analyst for inflation above and below the target Anser the question of whether a central bank follows a point target or a target rangr for inflation 2 LITERATURE REVIEW The nonlinear Taylor. .. can have asymmetric preference and, therefore, follow a nonlinear Taylor rule • If the central bank is indeed assigning different weights to negative and positive inflation and output gaps in it loss function • Then a nonlinear Taylor rule seems to be more adequate to explain the behavior of monetary policy • Asymmetries in monetary policy can result from a nonlinear macroeconomic model (Dolado et al.,... deviation of expected inflation k periods ahead (in annual rates) from its target value and the expected output gap p periods ahead, which yields the following forward-looking Taylor rule E: the expectations operator ̋t: a vector including all the available information for the central bank at the time it sets the interest rate Specification and estimation of the linear Taylor rule 3.1 The linear Taylor. .. evidence of an ECB respone to the exchange rate deviations from its average Exchange rate deviations Chadha et el (2004) found a similar result for - The FED - Bank of England - Bank of Japan Libik and Schorfheide (2007) found a similar result for - Central Banks of Canada - Central Banks of England 2 LITERATURE REVIEW Extent by cosidering the effect of other variables in the conduct of monetary policy. .. nonlinear monetary rule with other variables that provie information on the financial conditions - Be the first to apply a nonlinear model with smooth regime transition to the study of the ECB’s monetary policy Specification and estimation of the linear Taylor rule A basic linear Taylor rule is specified and estimated in this sec- tion We start by describing the rule in its contemporaneous and forward-looking... : October 1992 – December 2007 2 LITERATURE REVIEW Clarida et al (1998, 2000) Fourcans and Vranceanu (2004) Forwardlooking version Sauer and Sturm (2007) That practice allows the central bank to take various revelant variables into account when it forming its forecasts 2 LITERATURE REVIEW Extent by cosidering the effect of other variables in the conduct of monetary policy Fourcant and Vranceanu (2004)... (2) assuming that the central bank is able to control interest rates only up to an independent and identically distributed stochastic error (u): This rule can be easily extended to include an additional vector of other m explanatory variables (χ) that may potentially influence interest rate setting Specification and estimation of the linear Taylor rule 3.1 The linear Taylor rule Several theoretical... target past or current inflation but expected inflation ⇒ Clarida et al (1998) suggest the use of a forward-looking version of the Taylor rule That version allows the central bank to take various relevant variables into account when forming its inflation forecasts Specification and estimation of the linear Taylor rule 3.1 The linear Taylor rule The central bank’s desired level for interest rate (i*)... central banks Their results show that this indicator can be helpful in the modelling the conduct of monetary policy First aims of paper is simply to estimate a linear Taylor rule for the Eurozone, US and UK, where the information from some financial variables is accounted for to shed some more light on its (un)important 2 LITERATURE REVIEW The nonlinear Taylor rule • In reality, the central bank can. .. the centtral bank’s reaction function as a proxy for financial stability Kajuth (forthcoming) Monetary policy should also react to house price due to their effects on consumption 2 LITERATURE REVIEW The Future market and Financial stability Montagnoli and Napolitano (2005) They built and use a financial conditional indicator that includes the exchange rate, share prices in the estimation of a Taylor rule . Can central bank’s monetary policy be described by a linear (augmented) Taylor rule or by a nonlinear rule? BỘ MÔN TÀI CHÍNH QUỐC TẾ GS.TS Trần Ngọc Thơ GĐ A2 01 (E303) 23 Số 4 Danh. linear relation beween Interest Rate, Inflation and The Output Gap ASTRACT • Asset prices • Financial variables CONTENT OF PAPER ASTRACT The monetary behaviour of the European Central Bank. (ECB) and Bank of England (EOB) is best descibed by a nonlinear rule The behaviour of the Federal Reserve of the United States (FED) can be well descibed by a linear Taylor rule Only ECB is reacting