Forward-Looking Behavior and the Optimality of the Taylor Rule

FRB of San Francisco Working Paper No. 2001-03

38 Pages Posted: 13 Mar 2001

See all articles by Kevin J. Lansing

Kevin J. Lansing

Federal Reserve Banks - Federal Reserve Bank of San Francisco

Bharat Trehan

Federal Reserve Bank of San Francisco

Date Written: February 15, 2001

Abstract

This paper examines the optimal monetary policy under discretion using a small macroeconomic model that allows for varying degrees of forward-looking behavior. We quantify how forward-looking behavior affects the optimal response to inflation and the output gap in the central bank's interest rate rule. Specifically, we isolate the influence of forward-looking behavior in the aggregate demand equation, the wage contracting equation, and the term structure equation. We show that the data cannot uniquely identify the degree of forward-looking behavior in this class of models. Nevertheless, by imposing some assumptions about forward-looking behavior that are motivated by economic theory, we show that a plausible set of parameters can deliver the Taylor rule as the optimal monetary policy under discretion. We find that a successful parameter combination must include one or more of the following: (i) a high degree forward-looking behavior in the aggregate demand equation, (ii) a low degree of forward-looking behavior in the term structure equation, or (iii) a large (but still plausible) interest rate sensitivity parameter in the aggregate demand equation. More generally, our results show that a plausible set of model parameters can erase the distinction between "instrument rules" (such as the Taylor rule) and so-called "targeting rules" that represent the solution to a particular loss-minimization problem assigned to the central bank.

Keywords: monetary policy, inflation targeting, discretion, Taylor rule

JEL Classification: E31, E32, E43, E52, E58

Suggested Citation

Lansing, Kevin J. and Trehan, Bharat, Forward-Looking Behavior and the Optimality of the Taylor Rule (February 15, 2001). FRB of San Francisco Working Paper No. 2001-03, Available at SSRN: https://ssrn.com/abstract=262592 or http://dx.doi.org/10.2139/ssrn.262592

Kevin J. Lansing (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of San Francisco ( email )

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PO Box 7702
San Francisco, CA 94105
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415-974-2393 (Phone)
415-977-4031 (Fax)

Bharat Trehan

Federal Reserve Bank of San Francisco ( email )

101 Market Street
San Francisco, CA 94105
United States

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