Complutense University Library

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. [ Documentos de Trabajo de la Facultad de Ciencias Económicas y Empresariales; nº 07, 2009, ISSN: 2255-5471 ]

[img] PDF
Creative Commons Attribution Non-commercial Share Alike.


Official URL:


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
ID Code:9540

AARLE, B. VAN, H. GARRETSEN, F. HUART (2004): “Monetary and Fiscal Policy Rules in the EMU”, German Economic Review, 5 (4).

ASSO, P.F., G.A. KAHN, R. LESSON (2007): “The Taylor Rule and the Transformation of Monetary Policy”, Research Working Paper, Federal Reserve Bank of Kansas City, nº 07-11.

BALL, L. (1997): “Efficient Rules for Monetary Policy”, International Finance 2 (1).

BENATI, L., G. VITALE (2007): “Joint estimation of the natural rate of interest, the natural rate of unemployment, expected inflation and potential output”, ECB Working Papers, nº 797.

BENHABIB, J., S. SCHMITT-GROHÉ, M. URIBE (2001): “The perils of Taylor Rules”, Journal of Economic Theory, 96.

BLINDER, A. (1998): Central Banking in Theory and Practice, Cambridge (Mass.), MIT Press.

CLARIDA, R., J. GALÍ and M. GERTLER (1999): “The Science of Monetary Policy: a New Keynesian Perspective”, Journal of Economic Literature, XXXVII, december.

CARLIN, W., SOSKICE, D. (2006): Macroeconomics. Imperfections, Institutions and Policies, Oxford, Oxford University Press.

CRESPO CUARESMA, J., E. GNAN, D. RITZBERGER-GRÜNWALD (2005): “The natural rate of interest- Concepts and appraisal for the euro area”, Monetary Policy and the Economy, Q4/05, Oesterreichische Nationalbank.

GALÍ, J. (2008): Monetary Policy, Inflation, and the Business Cycle: An Introduction to the New Keynesian Framework, Princeton, Princeton University Press.

GREENSPAN, A. (1993): Testimony of Alan Greenspan before the Committee on Banking, Finance and Urban Affairs, US House of Representatives, July 20, US Government Printing Office.

ORPHANIDES, A. (2007): “Taylor rules”, FEDS Working Paper, No. 2007-18.

ORPHANIDES, A., J.C. WILLIAMS (2003): “Robust Monetary Policy Rules with Unknown Natural Rates”, FRBSF Working Papers, nº 2003-01.

REIS, R. (2003): “Where Is the Natural Rate? Rational Policy Mistakes and Persistent Deviations of Inflation from Target”, The B.E. Journal of Macroeconomics, 3 (1).

TAYLOR, J. (1998): “Monetary Policy Guidelines for Employment and Inflation Stability”, in R. SOLOW, J. TAYLOR, eds: Inflation, Unemployment and Monetary Policy, Cambridge (Mass.), MIT Press.

TAYLOR, J. (2008): The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong, Bank of Canada.

TAYLOR, J. (2009): “Systemic Risk and the Role of Government”, Conference on Financial Innovation and Crises, Federal Reserve Bank of Atlanta.

WOODFORD, M. (2003): Interest and prices. Foundations of a theory of monetary policy, Princeton, Princeton University Press.

WU, T. (2005): “Estimating the ‘Neutral’ Real Interest Rate in Real Time”, FRBSF Economic Letter, nº 2005-27, octubre.

Deposited On:16 Oct 2009 12:45
Last Modified:03 Dec 2015 13:11

Repository Staff Only: item control page