Taylor Rule Estimation by OLS

39 Pages Posted: 23 Oct 2018

See all articles by Carlos Carvalho

Carlos Carvalho

Government of the Federative Republic of Brazil - Central Bank of Brazil; Pontifical Catholic University of Rio de Janeiro (PUC-Rio) - Department of Economics

Fernanda Nechio

Federal Reserve Banks - Federal Reserve Bank of San Francisco

Tiago Tristão

Opus

Date Written: October 1, 2018

Abstract

Ordinary Least Squares (OLS) estimation of monetary policy rules produces potentially inconsistent estimates of policy parameters. The reason is that central banks react to variables, such as inflation and the output gap, which are endogenous to monetary policy shocks. Endogeneity implies a correlation between regressors and the error term, and hence, an asymptotic bias. In principle, Instrumental Variables (IV) estimation can solve this endogeneity problem. In practice, IV estimation poses challenges as the validity of potential instruments also depends on other economic relationships. We argue in favor of OLS estimation of monetary policy rules. To that end, we show analytically in the three-equation New Keynesian model that the asymptotic OLS bias is proportional to the fraction of the variance of regressors accounted for by monetary policy shocks. Using Monte Carlo simulation, we then show that this relationship also holds in a quantitative model of the U.S. economy. As monetary policy shocks explain only a small fraction of the variance of regressors typically included in monetary policy rules, the endogeneity bias is small. Using simulations, we show that, for realistic sample sizes, the OLS estimator of monetary policy parameters outperforms IV estimators.

Keywords: Taylor rule, OLS, GMM, endogeneity bias, New Keynesian models

JEL Classification: E52, E58, E50, E47

Suggested Citation

Carvalho, Carlos and Nechio, Fernanda and Tristão, Tiago, Taylor Rule Estimation by OLS (October 1, 2018). Available at SSRN: https://ssrn.com/abstract=3265449 or http://dx.doi.org/10.2139/ssrn.3265449

Carlos Carvalho (Contact Author)

Government of the Federative Republic of Brazil - Central Bank of Brazil ( email )

P.O. Box 08670
SBS Quadra 3 Bloco B - Edificio-Sede
Brasilia, Distr. Federal 70074-900
Brazil

Pontifical Catholic University of Rio de Janeiro (PUC-Rio) - Department of Economics ( email )

Rua Marques de Sao Vicente, 225/206F
Rio de Janeiro, RJ 22453
Brazil

HOME PAGE: http://https://sites.google.com/site/cvianac2/carloscarvalho

Fernanda Nechio

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

101 Market Street
San Francisco, CA 94105
United States

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