Working Paper: NBER ID: w11874
Authors: Troy Davig; Eric M. Leeper
Abstract: The paper generalizes the Taylor principle---the proposition that central banks can stabilize the macroeconomy by raising their interest rate instrument more than one-for-one in response to higher inflation---to an environment in which reaction coefficients in the monetary policy rule evolve according to a Markov process. We derive a long-run Taylor principle that delivers unique bounded equilibria in two standard models. Policy can satisfy the Taylor principle in the long run, even while deviating from it substantially for brief periods or modestly for prolonged periods. Macroeconomic volatility can be higher in periods when the Taylor principle is not satisfied, not because of indeterminacy, but because monetary policy amplifies the impacts of fundamental shocks. Regime change alters the qualitative and quantitative predictions of a conventional new Keynesian model, yielding fresh interpretations of existing empirical work.
Keywords: No keywords provided
JEL Codes: E31; E52; C62
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Taylor principle adherence (C51) | macroeconomic stability (E60) |
| Failure to satisfy Taylor principle (E31) | amplification of fundamental shocks (E32) |
| Failure to satisfy Taylor principle (E31) | larger fluctuations in output and inflation (E39) |
| Indeterminacy arises when Taylor principle not satisfied (D59) | multiple equilibria influenced by non-fundamental disturbances (D59) |
| Expectations of agents regarding future policy regimes (D84) | current economic outcomes (E66) |
| Brief deviations from Taylor principle (E19) | significant expectations formation effects (D84) |
| Expectations formation effects (D84) | impact on economic performance (F69) |