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The Taylor Rule and the Transformation of Monetary Policy

Editor(s):Koenig, Evan F.
Leeson, Robert
Kahn, George A.
Reviewer(s):Gentle, Paul F.

Published by EH.Net (April 2014)

Evan F. Koenig, Robert Leeson, and George A. Kahn, editors, The Taylor Rule and the Transformation of Monetary Policy. Stanford, CA: Hoover Institution Press, 2012. xix + 347 pp. $35 (hardcover), ISBN: 978-0-8179-1404-2.

Reviewed for EH.Net by Paul F. Gentle, NCC British Higher Education (Guangzhou, China).

This book explains the creation and application of the Taylor Rule, one of the most important and well-known rules of monetary policy. The volume includes chapters by Pier Francesco Asso, Ben Benanke, Richard Fisher, Otmar Issing, George Kahn, Evan Koenig, Donald Kohn, Robert Leeson, John Lipsky, Robert Lucas, Edward Nelson, Guillermo Ortiz, Lars Svensson, John Taylor, Michael Woodford and Janet Yellen. These chapters make it very clear that the Taylor Rule is one of the most important monetary policy devices to come along in the last three decades.

The volume provides a detailed history of economic thought, leading up to the Taylor Rule equation, then reviews applications of the Taylor Rule in the United States, the United Kingdom, Australia, Japan and other countries.  As the preface explains, “back in the late 1970s and early 1980s, John Taylor and a few others embraced the notion that households and firms are forward-looking in their decision-making and intelligent in forming their expectations, but rejected the view that wages and prices adjust instantaneously to their market-clearing levels” (p. vii).  In Taylor’s view of New Keynesian economics, consumers try to develop rational expectations about the future. Yet due to nominal frictions (sticky prices and sticky wages), market-clearing levels of wages and prices are not reached instantaneously.  “Taylor helped bridge the gap between monetary theory and applied monetary policy when he showed that the set of activist feedback rules consistent with a well-behaved equilibrium includes certain interest-rate rules” (p. xi). Due to the need to see how well different performance rules worked, Taylor “developed the Taylor Curve, which shows efficient combinations of output and inflation variability” (p. x). Keeping unemployment low and inflation low are goals that are especially important given both the Great Depression of the 1930s and the Great Inflation of the 1970s. Many rules or guidelines have been created to deal with these twin concerns.  The Taylor Rule attempts to do this and its results have often been very good, although many economists believe that the Taylor Rule should be used in conjunction with other policy rules.

Here is John Taylor’s expression of his rule:[1]

r = p + .5y + .5(p – 2) + 2

where r = the federal funds rate; p = the rate of inflation over the previous four quarters; and y = the percent deviation of real GDP from a target.

Convertibility of money to a commodity, such as gold, was one of the first rules for monetary policy.  However, now we have fiat money, which needs a rule or rules to govern its growth.  “The Taylor rule synthesized (and provided a compromise between) competing schools of thought in a language devoid of rhetorical passion” (p. 5). The Taylor Rule with its equal weights has the advantage of offering a compromise solution between y-hawks (output hawks) and p-hawks (price hawks).  The rule is intended as a formative guide to policy and actually describes the conduct of U.S. monetary policy during a period of macroeconomic stability.  This fact helped influence the embrace of the Taylor Rule by policy makers.  Federal Reserve Governor Kohn gives a historical perspective of past episodes, suggesting that the Fed acted gradually in a certain period of time, though not at the slower pace as in estimated Taylor rules.  “These rules do not account for changes in the Fed’s inflation target from 1987 to the second half of the 1990s while the Fed was pursuing opportunistic disinflation” (p. 82). And the Fed’s monetary policy deviated from the Taylor Rule, from 2003 to 2006, when the funds rate was kept below Taylor Rule prescription for a long time (p. 83).  Of course that deviation of the Federal Reserve has been criticized by many economists. The deviation resulted in too much credit, which led up to the U.S. housing bubble and its aftermath.

As mentioned previously, there is also the idea of the Taylor Curve (pp. 148-151). The diagram has a vertical axis that denotes the variance of output.  The variance of inflation is shown on the horizontal axis.  The Taylor equation has proven to be more useful for policy than the Taylor Curve.  The Taylor Rule equation provides prescriptions for monetary policy.  Then there’s the “Great Moderation” – the reduced volatility of inflation and output in the decades before the 2008 recession. Some economists argue that such a moderation can by more readily achieved by central bankers, if they try to follow the Taylor equation.  But Taylor also refers to the “Great Deviation” (p.163) – the period when the Taylor Rule was not followed, to the point of a boom, followed by a bust.  Several economists discuss the ideas of inflation forecasts and the Taylor Rule contending that “forecast targeting and instrumental rules (such as the Taylor Rule) are complementary, rather than alternatives” (p. 236).

Lars Svensson argues that the “institutional framework for monetary policy rests on three pillars:  1. There is a mandate for monetary policy from the government or parliamentary, normally to maintain price stability. 2. There is independence for the central bank to conduct monetary policy and fulfill the mandate. 3. There is accountability of the central bank for its policy and decisions (pp. 245 -246).  Taylor has done in his work with these ideas in mind.  According to former Fed chair Ben Bernanke, the influence of Taylor upon “monetary theory and policy has been profound indeed” (p. 277), while the current Fed chair, Janet Yellen, states that Taylor’s work and “his research has affected the way policy makers and economists analyze the economy and approach to monetary policy” (p. 281).

Ultimately, this book is well worth the read.  A large array, of distinguished contributors give the reader a spectrum of viewpoints about the Taylor Rule.  The views of the Fed and many other central banks are given.  The academic side of monetary theory as it relates to the Taylor rule is covered in detail.  Taylor has done his research work in academic settings, government settings and within the commercial areas of financial markets — and from all those perspectives economists in this book have provided valuable analysis and commentary.

Reference:
1. John B. Taylor, “Cross-Checking ‘Checking in on the Taylor Rule.’” Economics One blog, July 16, 2013,  http://economicsone.com/2013/07/16/cross-checking-checking-in-on-the-taylor-rule/

Paul F. Gentle is the author of articles in Applied Economics, Applied Economics Letters, Economia Internazionale, Banks and Bank Systems and China and World Economy. He has taught at Samford University, Peking University, University of International Business and Economics, and City University of Hong Kong.

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Subject(s):Financial Markets, Financial Institutions, and Monetary History
Geographic Area(s):General, International, or Comparative
North America
Time Period(s):20th Century: WWII and post-WWII