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Deviations from Rules-Based Policy and Their Effects

30 Pages Posted: 11 Jul 2014  

Alex Nikolsko‐Rzhevskyy

Lehigh University - Department of Economics

David H. Papell

University of Houston - Department of Economics

Ruxandra Prodan

University of Houston - Department of Economics

Date Written: May 14, 2014

Abstract

Rules-based monetary policy evaluation has long been central to macroeconomics. Using the original Taylor rule, a modified Taylor rule with a higher output gap coefficient, and an estimated Taylor rule, we define rules-based and discretionary eras by smaller and larger policy rule deviations, the absolute value of the difference between the actual federal funds rate and the federal funds rate prescribed by the three rules. We use tests for multiple structural changes to identify the eras so that knowledge of subsequent economic outcomes cannot influence the choice of the dates. With the original Taylor rule, monetary policy in the U.S. is characterized by a rules-based era until 1974, a discretionary era from 1974 to 1985, a rules-based era from 1985 to 2000, and a discretionary era from 2001 to 2013. With the modified Taylor rule, the rules-based era extends further into the 1970s and there is an additional rules-based period starting in 2006. We calculate various loss functions and find that economic performance is uniformly better during rules-based eras than during discretionary eras, and that the original Taylor rule provides the largest loss during discretionary periods relative to loss during rules-based periods.

Keywords: Taylor rule, monetary rules, discretion, structural changes

JEL Classification: E47, E52, E42

Suggested Citation

Nikolsko‐Rzhevskyy, Alex and Papell, David H. and Prodan, Ruxandra, Deviations from Rules-Based Policy and Their Effects (May 14, 2014). Available at SSRN: https://ssrn.com/abstract=2463781 or http://dx.doi.org/10.2139/ssrn.2463781

Alex Nikolsko-Rzhevskyy

Lehigh University - Department of Economics ( email )

620 Taylor Street
Bethlehem, PA 18015
United States

HOME PAGE: http://www.nikolsko-rzhevskyy.com

David H. Papell

University of Houston - Department of Economics ( email )

Houston, TX 77204-5882
United States

Ruxandra Prodan (Contact Author)

University of Houston - Department of Economics ( email )

Houston, TX 77204
United States

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