Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

The Taylor Rule: Is It a Useful Guide to Understanding Monetary Policy?

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

The Taylor Rule: Is It a Useful Guide to Understanding Monetary Policy?

Article excerpt

More than anyone else in the decade of the 1990s, John Taylor spurred research into the nature of the monetary policy pursued by the Federal Reserve System. Taylor has advanced a simple and intuitive reason for why the Fed has done a better job of controlling inflation since the early 1980s: It has raised the funds rate more aggressively in response to inflation. This article suggests a different perspective. The question should be how the Fed prevents inflation from arising in the first place, not how vigorously it responds to observed inflation.

1. TAYLOR'S RESEARCH AGENDA

Indisputably, the behavior of inflation improved in the 1980s under the leadership of Paul Volcker as chairman of the FOMC (Federal Open Market Committee) of the Federal Reserve System. John Taylor attributes the improved behavior of inflation to the Fed's increased aggressiveness in responding to realized inflation. Specifically, Taylor (1993, 1998, 1999a) argues that the FOMC sets an interest rate target based on the observed behavior of inflation and the amount of excess capacity in the economy. According to Taylor, before 1979, the FOMC raised the funds rate less than one-for-one with increases in inflation. After 1979, it raised the funds rate more than one-for-one with inflation.

Taylor presented his analysis to encourage discussion of how to move from discretion to explicit rules in the formulation of policy. His work advanced the cause of thinking about monetary policy as a systematic strategy by distilling systematic behavior from actual FOMC behavior. That is, he advanced a rule for monetary policy that was both prescriptive and descriptive. The policymaker could adopt Taylor's proposed rule as a systematization of what had worked in practice rather than as an ideal based solely on an abstract model of the economy.

Taylor deduced his rule from the observed behavior of the FOMC by emphasizing two aspects of that behavior. First, the FOMC uses a short-term interest rate as its policy instrument. Second, it sets its interest rate peg (the funds rate) based on the observed behavior of the economy. In the words of former FOMC chairman William McChesney Martin, the FOMC follows a policy of "leaning against the wind." It raises its interest rate peg when economic activity is "strong" and inflation undesirably "high," and conversely. In a broad sense, any characterization of monetary policy will possess the flavor of a Taylor rule.

For all these reasons, Taylor has stimulated much useful research on monetary policy. Furthermore, more than anyone else, he has conveyed the professional consensus in economics that policymakers should conduct policy with explicit, quantitative objectives and a clear strategy for achieving those objectives.

3. PUTTING THE TAYLOR RULE IN A MODEL

What problems arise in identifying the systematic part of monetary policy, especially the part that has led to better control of inflation since the early 1980s? To begin, the FOMC does not specify explicit numerical objectives or an explicit strategy for achieving such objectives. Members of the Federal Reserve have typically emphasized the discretionary aspects of monetary policy rather than the systematic aspects. (Gramley [1970] is a prototypical example.) What the economist sees is only the correlations between economic activity and the funds rate that emerge out of the policy process. In order to characterize monetary policy, the economist must infer both the FOMC's objectives and its strategy.

Even if one assumes that a functional form like the Taylor rule successfully predicts the behavior of the funds rate, what has one learned about the behavior of the FOMC? Unfortunately, the answer is "nothing" unless one has solved the identification (simultaneous equations bias) problem. One must determine that the functional form is a structural rather than a reduced form relationship. The former is a behavioral relationship that explains how the FOMC alters its policy instrument in response to the behavior of macroeconomic variables. …

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