Essays in Monetary Policy Rules

Abstract

Essays in Monetary Policy Rules by Postrick Lifa Mushendami

John Taylor‘s (1993b) rule has revived the interest and usefulness of instrument rules in the formulation of monetary policy both among academics and practitioners. Consequently, research in this area has increased to answer among other things, which policy rule closely represent the actual monetary policy formulation of the central bank, or what is the performance of these Taylor rules compared to alternative rules.This thesis intends to add both to the theoretical and empirical literature on monetary policy rules and structured as follows: Chapter 2 attempts to examine the implication of interest rate smoothing on the persistence of a technology and monetary policy shock. Using a closed economy model of Galí (2008), I show that interest rate smoothing (Taylor rule with lagged interest rate and backward looking Taylor rule) tend to protracts the persistence of a monetary policy shock, while it truncates the persistence of a technological innovation.
The persistence due to a monetary shock from the Taylor rule is however shorter, while that from a technology shock is longer. Thus, Taylor rule is considered superior to the Taylor rule with lagged interest rule or the backward looking Taylor rule when the economy is hit by a monetary policy shock. On the contrary, the Taylor rule with lagged interest rate and the backward looking Taylor rule is considered superior to the Taylor rule when the economy is faced with a technology shock. These results tend to suggest that a policy maker faces a trade off regarding the Taylor rule or the interest smoothing rules.

Chapter 3, attempts to rank the performance of targeting rules against instrument rules in the presence of a cost push shock. In particular, it compares the performance of the three targeting rules (namely domestic inflation targeting rule (DIT), consumer price inflation (CPI) based targeting rule, exchange rate peg (PEG) with the original Taylor rule and the Forward looking Taylor rules of Clarida, Galí and Gertler(1998), commonly known as the CGG(+1) and CGG(+4).

Using a small open economy, I show that the domestic inflation targeting rule simultaneously stabilizes the output gap and domestic inflation in the presence of a domestic technology shock and a foreign output innovation and hence superior. Among instrument rules I show that the Taylor rule is superior to its forward looking specifications CGG(+1) and CGG(+4). However, in the presence of a cost push shock the results are mixed. The domestic inflation targeting rule only stabilizes the domestic inflation, while the CGG(+1) minimizes the output gap volatilities the most. The CGG(+4) is the most inferior rule in this model and calibration, given that it maximizes the volatilities in the domestic inflation and the output gap.

Chapter 4, empirically tests whether developing countries respond to domestic demand conditions or merely responds to developments in international interest rates in their interest rate reaction function. I show that developing countries do not strictly subscribe to the Taylor principle in setting nominal interest rate. Moreover, they tend to respond to international interest rates, inflation and past interest rates. Chapter 5, concludes