Inflation Targeting and an Optimal Taylor Rule for an Open Economy: Evidence for Colombia 1990-2011

Abstract

An optimal monetary policy Taylor rule is developed for an open economy, which we then estimate following a Markov regime-switching model for quarterly data from Colombia during 1990-2011. We find two opposite monetary regimes characterized by different policy rules: until October 2000 the Central Bank of Colombia reacted only statistically to output gap changes while after October 2000, when inflation targeting was officially adopted, monetary policy reacted only statistically to changes in the inflation rate. The latter regime is consistent with the Taylor principle as shown analytically and verified empirically by a unit root test for a Markov regime-switching model.

Keywords: Optimal Taylor rule, inflation targeting, Taylor principle, Markov switching

JEL Classification: C24, E42, E52, E58, N16