44 Pages Posted: 27 Sep 2006
Date Written: August 28, 2006
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.
Keywords: regime change, indeterminacy, monetary policy
JEL Classification: E31, E52, C62
Suggested Citation: Suggested Citation
Davig, Troy and Leeper, Eric M., Generalizing the Taylor Principle (August 28, 2006). CAEPR Working Paper No. 2006-001. Available at SSRN: https://ssrn.com/abstract=932648 or http://dx.doi.org/10.2139/ssrn.932648