Generalizing the Taylor Principle
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
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
Date posted: September 27, 2006
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