Working Paper: NBER ID: w20237
Authors: Christoph E. Boehm; Christopher L. House
Abstract: We analyze the optimal Taylor rule in a standard New Keynesian model. If the central bank can observe the output gap and the inflation rate without error, then it is typically optimal to respond infinitely strongly to observed deviations from the central bank's targets. If it observes inflation and the output gap with error, the central bank will temper its responses to observed deviations so as not to impart unnecessary volatility to the economy. If the Taylor rule is expressed in terms of estimated output and inflation then it is optimal to respond infinitely strongly to estimated deviations from the targets. Because filtered estimates are based on current and past observations, such Taylor rules appear to have an interest smoothing component. Under such a Taylor rule, if the central bank is behaving optimally, the estimates of inflation and the output gap should be perfectly negatively correlated. In the data, inflation and the output gap are weakly correlated, suggesting that the central bank is systematically underreacting to its estimates of inflation and the output gap.
Keywords: Taylor rules; New Keynesian models; monetary policy; measurement error
JEL Codes: E3; E31; E4; E43; E5; E58
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Measurement error (C20) | Central bank response (E52) |
| Accuracy of observations (C90) | Strength of policy response (E63) |
| Estimates of inflation and output gap (E31) | Correlation between inflation and output gap (E31) |
| Measurement error (C20) | Taylor rule coefficients (E43) |
| Taylor rule coefficients (E43) | Economic outcomes (F69) |
| Central bank response (E52) | Economic indicators (E30) |