Generalizing the Taylor Principle

45 Pages Posted: 14 Sep 2006 Last revised: 12 Dec 2022

See all articles by Troy Davig

Troy Davig

Federal Reserve Bank of Kansas City

Eric M. Leeper

University of Virginia ; Indiana University at Bloomington - Department of Economics; National Bureau of Economic Research (NBER); George Mason University - Mercatus Center

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Date Written: December 2005

Abstract

The paper generalizes the Taylor principle---the proposition that central banks can stabilize the macroeconomy by raising their interest rate instrument more than one-for-one in response to higher inflation---to an environment in which reaction coefficients in the monetary policy rule evolve according to a Markov process. We derive a long-run Taylor principle that delivers unique bounded equilibria in two standard models. Policy can satisfy the Taylor principle in the long run, even while deviating from it substantially for brief periods or modestly for prolonged periods. Macroeconomic volatility can be higher in periods when the Taylor principle is not satisfied, not because of indeterminacy, but because monetary policy amplifies the impacts of fundamental shocks. Regime change alters the qualitative and quantitative predictions of a conventional new Keynesian model, yielding fresh interpretations of existing empirical work.

Suggested Citation

Davig, Troy and Leeper, Eric Michael, Generalizing the Taylor Principle (December 2005). NBER Working Paper No. w11874, Available at SSRN: https://ssrn.com/abstract=875725

Troy Davig

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Eric Michael Leeper (Contact Author)

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