Academic journal article Contemporary Economic Policy

Are Policy Rules Better Than the Discretionary System in Taiwan?

Academic journal article Contemporary Economic Policy

Are Policy Rules Better Than the Discretionary System in Taiwan?

Article excerpt

Ruey Yau (*)

This article investigates whether the Central Bank of China in Taiwan (CBC) would have had a more successful monetary policy during the period 1978:3 to 1999:4 if it had followed an optimal rule rather than the discretionary policies that were actually employed. The article examines the use of three different instruments--the rediscount rate, M2, and reserve money--with several different targets--the growth rate of nominal output, inflation, the percentage change in the exchange rate, and the growth rate of a monetary aggregate. Only 4 of 64 rules considered resulted in a statistically significant improvement in the performance of the Taiwanese economy. Given that this study analyzes the economy of Taiwan with revised data that were not available to the CBC in real time, and given that so few of the rules would have improved the economy's performance, it is concluded that the performance of the CBC has been very good. (JEL E52, F41)


How well has the Central Bank of China in Taiwan (CBC) implemented monetary policy during the past three decades? With the exception of two inflationary episodes during periods of oil-price shocks (1973-74 and 1979-81), as far as inflation is concerned, the historical record suggests that monetary policy in Taiwan has been very successful. Figure 1 shows that during other periods the rate of inflation in Taiwan typically has been relatively low, usually between 0% and 5% per year during 1982-98 and falling to -2% at the end of 1999.

But could the CBC have performed much better than it actually did? That is, could it have achieved a less variable rate of inflation without increasing the variability of output? Because Taiwanese monetary policy has been discretionary, rather than based on a formal rule, there is a strand of macroeconomic theory that suggests the answer to this question must be yes. If the structure of the Taiwanese economy is such that an unexpected increase in the rate of inflation causes output to increase, then policy makers have an incentive to increase inflation. This implies that a discretionary monetary policy will have an inflationary bias (Kydland and Prescott, 1977; Barro, 1986). The existence of this inflationary bias makes it difficult for policy makers to lower expected inflation without first earning a reputation for price stability. A solution to this reputation or credibility problem is for the monetary authority to follow an explicit formal rule that eliminates its discretion to inflate. It therefore follow s that a monetary policy implemented according to a rule will achieve lower inflation than a discretionary monetary policy. For example, Judd and Motley (1991, 1992, 1993) and McCallum (1988) have examined the empirical properties of nominal feedback rules and find that the use of simple feedback rules could have produced price stability for the United States over the past several decades without significantly increasing the volatility of real output.

The purpose of this article is to examine whether the CBC would have had a more successful monetary policy if it had followed an explicit rule rather than the discretionary policies actually implemented. We use an approach similar to those of Judd and Motley (1991, 1992, 1993) and McCallum (1988, 1993) to evaluate the performances of policy rules. But the methodology employed here differs from that of the above writers in two ways. First, following Svensson (1998), this article divides proposed rules for monetary policy into two broad groups, instrument rules and targeting rules. Second, when this article examines instrument rules, as is explained in section III below, it analytically solves for the policy response parameter that minimizes the variance of inflation, something not done by previous writers.

Instrument rules require that the central bank adjust its policy instrument in response to deviations between the actual and desired value of one or more variables being targeted by the monetary authority. …

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