Introduction
Commitment to an interest rate rule would be dangerous because the labor and products markets could not rescue the economy from the consequences of an error in the rule” (E Phelps, Financial Times, 2006). The statement made by E. Phelps is related to a monetary policy to be used based on Taylor’s rule.
The Taylor rule
Taylor recommended that there should be a target for the level of the nominal federal funds rate that depends on four factors. These factors are (1) the current inflation rate. (2) the equilibrium real interest rate. These two factors provide a benchmark recommendation for the nominal federal funds rate. (3) Inflation gap adjustment factor based on the gap between the inflation rate and a given target for inflation. ( 4) output gap adjustment factor based on the gap between real GDP and potential real GDP.
“The two factors give a standard recommendation for the federal funds rate that would keep inflation at its current rate, provided the economy is operating at its potential. Because the benchmark recommendation rises one-for-one with the current rate of inflation, the higher current inflation is, the higher the rule recommendation will be, all else equal. This relationship between current inflation and the benchmark recommendation for the nominal federal funds rate keeps the implied real interest rate constant.
The use of the equilibrium real rate in the Taylor rule emphasizes that real rates play a central role in formulating monetary policy. Although the nominal federal funds rate is identified as the instrument that policymakers adjust, the real interest rate is what affects real economic activity. In particular, the rules clarify that real interest rates will be increased above equilibrium when inflation is above target or output is above its potential.
The third and fourth factors in the Taylor rule summarize two objectives of monetary policy. targeting a low and stable rate of inflation while promoting maximum sustainable growth. These adjustment factors can also be seen as incorporating both long-run and short-run goals. The inflation gap adjustment factor incorporates the central bank.s long-run inflation goal. The output gap adjustment factor incorporates the view that in the short-run policy should lean against cyclical winds. Weights in the adjustment factors embody a presumed attitude toward the short-run tradeoff between inflation and output. The output gap adjustment factor may represent another aspect of policy. Some analysts have argued that the output gap adjustment factor brings a forward-looking, or preemptive, motive to policy recommendations. According to this view, a positive output gap signals likely future increases in inflation. Consequently, funds rate recommendations that reflect an output gap adjustment may correspond to policy actions designed to preempt an otherwise anticipated increase in inflation.
Although the Taylor rule incorporates many important aspects of policy, it also is based on several assumptions. Assumptions of some form are necessary to move from a framework for policy to a rule that provides quantitative recommendations.
The specific rule discussed by Taylor takes the following form:
funds rate(t) = GDP price inflation(t)
+ 2.0 + 0.5 ´ (GDP price inflation(t). 2.0)
+ 0.5 ´ (output gap(t)). (1)
In this expression, the benchmark recommendation is the sum of GDP price inflation and the 2.0 percent equilibrium real rate. The third term on the right side of the expression is the inflation gap adjustment, which raises the fund’s rate target by one-half of the gap between GDP price inflation and the 2.0 percent inflation target. The fourth term on the right side of the expression is the output gap adjustment, which raises the fund’s rate target by one-half of the output gap, where the output gap is defined as the percent deviation of the level of real GDP from the level of potential real GDP.
Assumptions are embedded in all components of the rule. Taylor-rule recommendations in a given quarter are based on the output gap in the same quarter and on inflation over the four quarters ending in the same quarter. In the Taylor rule, monetary policy targets GDP price inflation measured as the rate of inflation in the GDP deflator over the previous four quarters. The equilibrium real rate, represented by the second term on the right side of the expression, is assumed to equal 2.0 percent. The inflation gap adjustment incorporates a weight equal to one-half.
The policy target for inflation is assumed to equal 2.0 percent. The output gap adjustment incorporates a weight equal to one-half. And, the output gap is constructed using a series for potential real GDP that grows 2.2 percent per year” Federal Reserve Bank of Kansas City and Kazicki S; (1999) Phelps argued in his article that “ Should the natural interest rate drop below the level the rule took it to be, no fall in prices and wages could restore unemployment to its natural rate: their fall would pull down the money supply with them, leaving no net restorative effect”. This argument shows how the interest rate rule can affect the supply of money in the economy. Phelps continued in the article, “The possibility exists, then, that the quantitative rule selected would leave the natural interest rate well below the real interest rate required by the rule in some periods, thus risking a slump, and well above it in other periods, thus risking rising inflation. Or, possibly, the rule would be pitched too high (or too low) all the time, owing to a large overestimate (or underestimate) of the range in which the natural rate will lie in the future”.
From the above arguments, we shed doubt on the conclusion and point out that the ability of an active monetary policy to ensure determinacy depends heavily on the economic conditions. Benhabib, Schmitt-Grohe, and Uribe (2001) and Carlstrom and Fuerst (2001) argued that the preference specification is another crucial element that further limits the scope for a stabilizing rule. Different preference specifications fundamentally alter the results. Carlstrom and Fuerst (2005) further argued that even moderate assumptions on the structure of the economy, such as the presence of investment spending, might drastically affect results. In the presence of investment, an active current-looking or backward-looking policy guarantees determinacy, while a forward-looking policy always generates indeterminacy.
There are many dangers to economy at large if the central bank (federal bank) commits to the rule. Mr Tylor noted in his report to the President that the rule should not mechanical but as a guide. This means that the rule should be followed after taking into account other factors. “For monetary policy to foster maximum sustainable economic growth, it is useful to preempt forces of imbalance before they threaten economic stability. However, this may not always be possible—the future at times can be too opaque to penetrate. When we can be preemptive, we should be, because modest preemptive actions can obviate more drastic actions later that would destabilize the economy. (Greenspan, 1999) To me, the effective time to act against inflationary pressures is when they are in the development stage—before they have become full-blown and the damage has been done. Precautionary measures are more likely to be effective than remedial action: the old proverb that an ounce of prevention is worth a pound of cure applies to monetary policy as well as to anything else”.
We realize that the failure of the factors of the rule will lead to great inflationary that will in turn lead to less sustainable development and un employment in the economy.
Many policy makers have tried to use the formulas to measure Taylor rule factors but briefly, some of factors are had to measure. Take for example measuring the rate of unemployment. It will be very had to allocate some empirical formula that will lead to the right answer.
Conclusion
“Inflation is affected by both expected future inflation and lagged inflation, the performance of price-level targeting deteriorates significantly as the relative weight on lagged inflation rises (Walsh 2003b). Levin and Williams (2003a) demonstrate that policy rules that are optimal in a forward-looking model can lead to disastrous results if the true model is in fact backward-looking.
Unfortunately, given the significance it has for the evaluation of alternative policies, there is great uncertainty about the respective roles of forward and backward elements in the inflation process”. Using the formulae below; “i=real interest rate+inflation rate+h(inflation rate-desired inflation rate(inflation*)+b(log output-log equilibrium output)”.
In their findings Walsh (2003c), Coenen (2003) and Angeloni, Coenen, and Smets (2003), reported in where the costs of underestimating h were found to be larger, and they concluded that it is better to over-estimate inflation. When adjust output upward and the equilibrium you are decreasing inflation. This also applies to labour market. However, the policy maker will be in a difficulty position where he relies on the formula in his decision-making. This because of the findings where the inflation was not actually affected by labour and output.
References
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Benhabib, J. and Schmitt-Grohé, S. and Uribe, M. (2001b),”Monetary policy and multiple equilibria”, American Economic Review 91, 167-186.
Carlstrom, C. T. and Fuerst, T. S. (2001a), ”Timing and real indeterminacy in monetary models”, Journal of Monetary Economics 47, 285-298.
Carlstrom, C. T. and Fuerst, T. S. (2001b), ”Real indeterminacy and in monetary models with nominal interest rare distortions”, Review of Economic Dynamics 4, 767-789.
Federal Reserve Bank of Kansas city and Kazicki S; (1999) how useful are Taylor rules for monetary policy.
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Phelps E (2006); Do not get fixated on a fixed interest rate rule; Financial times
Taylor, J. B. (1993), ”Discretion versus policy rules in practice”, Carnegie Rochester Series on Public Policy,