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Generalizing the Taylor Principle


Troy Davig


Federal Reserve Bank of Kansas City

Eric M. Leeper


Indiana University at Bloomington - Department of Economics; National Bureau of Economic Research (NBER); Monash University, Department of Economics

August 28, 2006

CAEPR Working Paper No. 2006-001

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.

Number of Pages in PDF File: 44

Keywords: regime change, indeterminacy, monetary policy

JEL Classification: E31, E52, C62

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Date posted: September 27, 2006  

Suggested Citation

Davig, Troy and Leeper, Eric M., Generalizing the Taylor Principle (August 28, 2006). CAEPR Working Paper No. 2006-001. Available at SSRN: http://ssrn.com/abstract=932648 or http://dx.doi.org/10.2139/ssrn.932648

Contact Information

Troy Davig (Contact Author)
Federal Reserve Bank of Kansas City ( email )
1 Memorial Dr.
Kansas City, MO 64198
United States
Eric Michael Leeper
Indiana University at Bloomington - Department of Economics ( email )
304 Wylie Hall
Bloomington, IN 47405-6620
United States
812-855-9157 (Phone)
812-855-3736 (Fax)

National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
Monash University, Department of Economics ( email )
Wellington Road
Clayton, Victoria 3168
Australia
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