Working Paper: CEPR ID: DP7341
Authors: Agostino Consolo; Carlo A. Favero
Abstract: Empirical estimates of monetary policy reaction functions feature a very high estimated degree of monetary policy inertia. This evidence is very hard to reconcile with the alternative evidence of low predictability of monetary policy rates. In this paper we examine the potential relevance of the problem of weak instruments to correctly identify the degree of monetary policy inertia in forward looking monetary policy reaction function of the type originally proposed by Taylor (1993). After appropriately diagnosing and taking care of the weak instruments problem, we find an estimated degree of policy inertia which is significantly lower than the common value in the empirical literature on monetary policy rules.
Keywords: Monetary Policy; Rules; Weak Identification
JEL Codes: E52; E58; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| high estimated degree of monetary policy inertia (E49) | weak instruments problem (C26) |
| weak instruments problem (C26) | upward bias in estimates of monetary policy inertia (C54) |
| addressing weak instruments (C26) | lower estimates of monetary policy inertia (C54) |
| weak instruments (C26) | illusion of high monetary policy inertia (E41) |
| future inflation treated as dependent variable (E31) | lower estimate of policy inertia (D15) |
| traditional specification (Y20) | higher estimates of policy inertia (C54) |
| high persistence of monetary policy rates (E52) | low predictability at longer horizons (G17) |