Optimal Taylor Rules in New Keynesian Models

39 Pages Posted: 23 Jun 2014 Last revised: 22 Oct 2014

See all articles by Christoph Boehm

Christoph Boehm

University of Texas at Austin

Christopher L. House

University of Michigan at Ann Arbor - Department of Economics; National Bureau of Economic Research (NBER)

Date Written: June 2014

Abstract

We analyze the optimal Taylor rule in a standard New Keynesian model. If the central bank can observe the output gap and the inflation rate without error, then it is typically optimal to respond infinitely strongly to observed deviations from the central bank's targets. If it observes inflation and the output gap with error, the central bank will temper its responses to observed deviations so as not to impart unnecessary volatility to the economy. If the Taylor rule is expressed in terms of estimated output and inflation then it is optimal to respond infinitely strongly to estimated deviations from the targets. Because filtered estimates are based on current and past observations, such Taylor rules appear to have an interest smoothing component. Under such a Taylor rule, if the central bank is behaving optimally, the estimates of inflation and the output gap should be perfectly negatively correlated. In the data, inflation and the output gap are weakly correlated, suggesting that the central bank is systematically underreacting to its estimates of inflation and the output gap.

Suggested Citation

Boehm, Christoph and House, Christopher L., Optimal Taylor Rules in New Keynesian Models (June 2014). NBER Working Paper No. w20237, Available at SSRN: https://ssrn.com/abstract=2457712

Christoph Boehm

University of Texas at Austin ( email )

2317 Speedway
Austin, TX 78712
United States

Christopher L. House

University of Michigan at Ann Arbor - Department of Economics ( email )

611 Tappan Street
Ann Arbor, MI 48109-1220
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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