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Generalizing the Taylor Principle

44 Pages Posted: 27 Sep 2006  

Troy Davig

Federal Reserve Bank of Kansas City

Eric M. Leeper

Indiana University at Bloomington - Department of Economics; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: August 28, 2006

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.

Keywords: regime change, indeterminacy, monetary policy

JEL Classification: E31, E52, C62

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

Troy Davig (Contact Author)

Federal Reserve Bank of Kansas City ( email )

1 Memorial Dr.
Kansas City, MO 64198
United States

Eric Michael Leeper

Indiana University at Bloomington - Department of Economics ( email )

304 Wylie Hall
Bloomington, IN 47405-6620
United States
812-855-9157 (Phone)
812-855-3736 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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