Benefits and Limitations of Taylor rule

Donald Kohn has a nice oldish speech on Taylor rules. The speech was given in this Dallas Fed conference in the honor of John Taylor.

3 benefits:

  • The first benefit of looking at a simple rule like John’s is that it can provide a useful benchmark for policymakers.  It relates policy setting systematically to the state of the economy in a way that, over time, will produce reasonably good outcomes on average.
  • A second benefit of simple rules is that they help financial market participants form a baseline for expectations regarding the future course of monetary policy.
  • A third benefit is that simple rules can be helpful in the central bank’s communication with the general public.  Such an understanding is important for the transmission mechanism of monetary policy

4 limitations:

  • The first limitation is that the use of a Taylor rule requires that a single measure of inflation be used to obtain the rule prescriptions.  The price index used by John in the Carnegie Rochester paper was the GDP price deflator.  Other researchers have used the inflation measure based on the consumer price index (CPI).  Over the past fifteen years, the Federal Reserve has emphasized the inflation rate as measured by changes in the price index for personal consumption expenditures (PCE). 
  • Second, the implementation of the Taylor rule and other related rules requires determining the level of the equilibrium real interest rate and the level of potential output; neither of them are observable variables, and both must be inferred from other information. 
  • The third limitation of using simple rules for monetary policymaking stems from the fact that, by their nature, simple rules involve only a small number of variables.  However, the state of a complex economy like that of the United States cannot be fully captured by any small set of summary statistics.
  • The final limitation I want to highlight is that simple policy rules may not capture risk-management considerations.  In some circumstances, the risks to the outlook or the perceived costs of missing an objective on a particular side may be sufficiently skewed that policymakers will choose to respond by adjusting policy in a way that would not be justified solely by the current state of the economy or the modal outlook for output and inflation gaps.    

He then looks at these limitations and applies it on policy real time.  He shows how applying the Taylor rules in real time leads to difficulties. Pretty much what Bernanke said in his recent speech.

4 Responses to “Benefits and Limitations of Taylor rule”

  1. An exit rule from John Taylor « Mostly Economics Says:

    […] saying based on rules etc. It is a good theoretical idea but is it easy to implement?  Don Kohn has already looked at limitations of Taylor rule in real time […]

  2. V Weber Says:

    Greetings Just Price per God not Fed Res playing God
    “End The Fed” Rep. Ron Paul
    “The Liberty Dollar Solution To The Federal Reserve” B.V. NotHaus
    2Maccabees 3:22-40 God’s Divine Presence St. Paul convert US
    Prayerfully v

  3. An alternative rule to Taylor rule « Mostly Economics Says:

    […] same ideas were discussed by Bernanke and Kohn in their speeches (Taylor responded as […]

  4. Ben Bernanke vs John Taylor …again « Mostly Economics Says:

    […] Fed kept policy rates much lower in 2003-06 than what his Taylor rule predicted. Bernanke (and Kohn) gave a stirring speech saying Taylor rule does not work in real-time policy.  Taylor responded to […]

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