Monetary Policy Switch, the Taylor Curve, and the Great Moderation
29 Pages Posted: 2 Feb 2006
Date Written: January 2006
This paper employs a standard new Keynesian model to compute the inflation/output volatility frontier, i.e. the Taylor curve. The computation is performed both under equilibrium uniqueness and under indeterminacy. While under uniqueness the Taylor curve looks like expected - i.e. a monotonically decreasing curve in the (σx, σπ) diagram -, under indeterminacy a new result arises. We find that the tighter is the monetary policy, the higher is the inflation/output gap volatility. This is due to impact of systematic monetary policy on inflation and output persistence. In fact, under indeterminacy a more aggressive monetary policy causes an increase in inflation persistence, and augments its volatility. The effects on output tend to be of opposite sign. This finding is robust to different parameterizations of the DSGE new-Keynesian monetary model employed. This result i) offers support to the move from passive to active monetary policy as one of the possible rationales for the Great Moderation, ii) underlines the need of a deeper understanding of the link between systematic monetary policy and macroeconomic persistence, and iii) warns against sub-samples pooling when performing macroeconometric analysis.
Keywords: Taylor principle, Taylor curve, new Keynesian model, indeterminacy, persistence
JEL Classification: E30, E52
Suggested Citation: Suggested Citation