Alonso González, Alberto and Uxó González, Jorge
(2009)
*Two problems of the Taylor rule and a proposal: the tracking rule.*
[Working Paper or Technical Report]

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Official URL: http://eprints.ucm.es/9540/

## Abstract

This paper deals with some problems related to the application of monetary policy following

the Taylor Rule in the theoretical context of a “3-equation model”. The first problem arises if the

real interest rate does not affect the equilibrium income level itself –as in the IS curve- but its

rate of growth –as in the dynamic IS that we propose. Secondly, the Taylor Rule is incapable of

reaching the inflation target when the central bank does not correctly estimate its parameters

(the neutral interest rate and potential income) or these parameters vary. Our objective is to

propose an alternative to the Taylor Rule which overcomes both problems. This alternative has

been called the Tracking Rule, because instead of trying to estimate the neutral interest rate or

the potential output, the central bank “tracks” these values based on the economy’s evolution,

particularly on variations in the inflation and unemployment rates. After justifying the dynamic IS

and explaining the logic of this rule in detail, the paper compares the Tracking Rule with the

Taylor Rule, simulating both of them in the context of different types of shock in the modified

three equation model. The results, measured by a loss function, show that the Tracking Rule is

superior in every single case. It is particularly interesting to evaluate central bank reactions

derived from the two rules when the economy suffers a large contractive shock such as the

current crisis. The results show that, with the same shock, the economy is more likely to fall into

the liquidity trap when the Taylor Rule is applied.

Item Type: | Working Paper or Technical Report |
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Additional Information: | JEL codes: E52, E58 |

Uncontrolled Keywords: | Monetary Policy, Taylor Rule, Liquidity Trap, Simulations |

Subjects: | Social sciences > Economics > Money |

Series Name: | Documentos de Trabajo de la Facultad de Ciencias Económicas y Empresariales |

Volume: | 2009 |

Number: | 7 |

ID Code: | 9540 |

Deposited On: | 16 Oct 2009 12:45 |

Last Modified: | 14 Jan 2014 09:45 |

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