Academic journal article Economic Inquiry

Monetary Policy Regime Shifts: New Evidence from Time-Varying Interest Rate Rules

Academic journal article Economic Inquiry

Monetary Policy Regime Shifts: New Evidence from Time-Varying Interest Rate Rules

Article excerpt

I. INTRODUCTION

Interest rate policies are complex decisions. They rely on a multitude of indicators and models and are by nature associated to events not always captured by relatively simple econometric tools. Nonetheless, there is now a widespread consensus that the class of simple policy rules examined by recent microfounded models of the economy generates stabilization properties that are very close to those of optimal feedback rules (Woodford 2003). Feedback rules nowadays are customary tools for monetary policy analysis. Furthermore, rule-based policymaking is generally accepted as the reference framework of monetary policy strategies (Bank of England 1999; European Central Bank 2004).

Monetary policy reaction functions summarize the importance that policymakers attach to policy objectives as well as their views on the structure of the economy. Traditionally, those functions are estimated as constant parameters policy rules. This is a plausible simplification, but a number of reasons suggest that rules should allow for instability and parameter variation over time. Constant parameter reaction functions might blur the role played by various real-world factors: (1) model uncertainty, (2) conflicting objectives, (3) shifting preferences on policymakers' choices, and (4) nonlinearities. In particular, reduced-form policy models that do not allow for shifts and asymmetries in behavioral relationships could produce misleading results. Dynamic stochastic general equilibrium (DSGE) models represent one potentially promising way of overcoming these problems. This increasingly popular approach is based on microfounded descriptions of the economy. Recent studies also provide novel techniques to estimate and evaluate linearized DSGE models using Bayesian methods (Del Negro et al. 2007). The Bayesian framework represents a natural setup to account for model and parameter uncertainty. However, the DSGE approach imposes a large number of restrictions on the data. In the specific context of interest rate rules, its ability to generate qualitative and robust assessments on monetary policy conduct appears problematic.

This article provides some new evidence on interest rate policies in five large economies (United States, United Kingdom, Germany, France, and Italy) through the implementation of a time-varying parameters approach (TVP henceforth). We estimate policy rules as summarized by simple reaction functions defined in terms of expected inflation and output gaps. In contrast with most existing analyses, we employ a TVP methodology based on the Kalman filter algorithm to estimate our instrument rules. In practice, we allow the policy rules' coefficients to vary over time. What we obtain are estimates of the state vector for each observation in our sample. These estimates can then describe the evolution of monetary policy over time. Moreover, we evaluate the conditional variance of interest rates implied by our TVP methodology.

A host of factors may cause shifts in the estimated parameters of monetary policy reaction functions. Some of them may be due to institutional reforms like the introduction of inflation targets or the move to an exchange rate peg or a fixed exchange rate. In estimating reaction functions defined in terms of final policy objectives, one aims at capturing the relative emphasis placed by policymakers on the attainment of output and inflation targets. Over time, such emphasis might evolve. Therefore, one needs to model the observer's view on the likelihood that these shifts are smooth transitions or abrupt regime changes. By allowing the weights of the policy rule to vary only gradually, we are able to identify relevant shifts in policy conduct, regardless of their exact configuration. As argued at length in the next section, our approach is better suited than conventional fixed-parameter techniques to deal with Lucas critique and, more in general, with the issue of structural change. …

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