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Two problems of the Taylor rule and a proposal: the tracking rule

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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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
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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