Taylor's Rule - rushtermpapers

Taylor’s Rule

Taylor’s Rule is common in economics, findings indicated that the model is a monetary policy rule guiding on the way the central bank changes the nominal interest rate depending on the economic conditions, issues of inflation and the national output conditions (Koenig, 2012). Taylors principle argues that if the inflation rate changes by a mere one cent, then it’s expected that central bank have the responsibilities of increasing the nominal interest rate by margins not less than one point at that particular time (Bernanke, 2013). The main intention of the Taylor rule in federal funds rate is to foster stability of the prices, increase credibility basing on the future actions and in reducing uncertainty. Taylor principle is also influential in minimizing inconsistency and inefficiencies caused by the discretionary policies.

Federal funds rate in the United States refers to the interest rates traded by the depository institutions. The funds are called federal funds under the watch of the Federal Reserve. It has been noted that organizations characterized with surplus balances reflecting on their accounts are expected to lend other institutions with weak balances as per their accounts (Blinder, 2009). Financial markets in the United States heavily rely on the federal funds rate in setting the benchmark. It is the responsibility of the financial institutions to negotiate the interest rates. Federal funds effective rate reflects on the weighted average agreed upon by the lending institutions (Mishkin, 2009).

Determination of the federal funds rate is made after Federal Open Market Committee discusses on the issues and comes up with a viable solution, the meetings are scheduled to take place in yearly basis, mainly eight times, depending on demand; and additional meetings may take place in implementing and addressing changes in rates. Supply of funds in the economy of the United States is implemented by the open market operations, which is under the Federal Reserve, with the target value focusing on neutral federal funds rate where the inflation rate and the Gross Domestic Product (GDP) are stable (Koenig, 2012).

Monetary policy in the recent past has been very accommodative considering that the policy rates has been kept as low as possible by the central banks, a move that has expanded the balance sheets of the central banks, a practice critical in handling times of crisis like high inflation rates (Blinder, 2009). The past decades, that has been rising questions on the effectiveness of the monetary policies actions since the current systems are to some extent declining in playing the expected roles.

United States has an advanced economy, in graphs 6.1; there are indications that emerging market economies and also advanced economies are considering low policy trends, while at the same time maintaining a high nominal rate (Bis.org, 2012). The move has led to very low real rates comparing to the developed economies. Advanced economies considered the United States, United Kingdom, Japan, Euro area and other advanced economies. Emerging market economies reflected on Latin America, Asia and other SMEs.

Graphs 6.5 reflected on exit strategies, it has been noted the current policy has been accommodating, and that exiting for the system presents demanding situations from the central banks, in weighing the risks associated with exiting later and the risks associated with exiting prematurely (Bis.org, 2012). In both instances, risks are every in place; it is only the timing that differs. Individual circumstances of the central banks will shape the pace and the timing of the exit. Forward curves as observed in the graphs 6.5 indicating that the policy rates were expected to remain at low levels for sometime before picking up in later years. It is expected that new developments will come into place, resulting to discontinuities as the strategies developed by diverse central banks evolve, hence shaping the effectiveness of the systems (Bis.org, 2012).

In the past decades, it has been noted that the central banks are working closely in making operational capabilities flexible and strong, in a way to manage exit effectively. Central bank has wide options basing on the excess interests on reserve, deposit facilities and aspects of repos; the moves in return influence the balance sheet and the policy rates designed to meet the needs of diverse central banks. The model of communication offered by the central banks influence the exit strategies, in a way that the private sector increases the trust on central banks, a move that shape the efficiency of the policy goals (Bis.org, 2012). Graphs 6.5 primarily focused on United States, Euro area, United Kingdom and Japan. It was noted that raising the policy rate by the Federal Reserve resulted to sharp increments considering yield curves around the globe.

Graphs 6.6 reflected on the Taylor rule estimates and the policy rates, it was noted that Taylor rule linked the policy rates in understanding output gap and inflation. Monetary policy as observed in advanced economies indicated that such nations has experienced accommodative environment (Bis.org, 2012).

Interest rates can never be less than zero as suggested by the Taylor rule. Zero lower bound (ZLB) is non-existence, since Federal Reserve theoretically and practically cannot let the nominal interest be 0%, since people would reject purchasing assets. A negative rate would mean that people would hoard cash, which would indicate that nominal interest rates of 0% would not be effective in a market economy. The interest rate is critical since it influences how people spend or save their cash. Lower interest rates are characterised with people spending more and at the same time save very little than high interest rates, where people spend less and save more (Bernanke, 2013).

If the interest rate in zero, it means that Federal Reserve will have no powers of lowering it further, hence Federal Reserve will be held at a stagnant point, since consumer spending cannot be altered. Taylors rule suggests that the interest rates for the federal funds should be above zero, and never less than zero. Less than zero interest rates would mark a recession. Cutting government spending reduces employment and GDP while increasing government spending increases the GDP and employment, which has no long run adverse effects.

According to Taylor rule, it can be argued that the federal funds rates are too low, since the Federal Reserve is trying to promote high employment rates and high GDP, in a way that the downward sloping represents optimisms, an indication that the inflation rate is kept as low as possible. There are high possibilities that high inflation leads to cases of high unemployment rates in the United States, which results to pessimism.

Inflation rates in the United States stands at 2%, although the percentages keeps on changing, this is recorded in US by the Bureau of Labour Statistics. Unemployment rates estimated at twelve million people or 7.4% of unemployment although the figures keep on changing (Blinder, 2009). Federal funds rate stands at 2%.

Taylor’s Rule Graph

r=p+0.5y+0.5(p-2)+2

r represents federal state rate

p represents rate of inflation

y represents real GDP percent deviation

u represents unemployment

y=1.5(5.5%-u)

r=p+0.5y+ 0.5(p-2)+2 substituting y results in

r=p+0.75(5.5%-u)+0.5(p-2)+2 substituting u=5.5%

r=p+0.5(p-2)+2

r=p+0.5p-1+2

r=1.5p+1 substituting in r=p+0.5(p-2)+2

0.5p+1=p+0.5(p-2)+2

0=p

y=1.5(5.5%-u) where u=5.5

y=0

r=1.5p+1

r=1.5(0)+1

r=1

Therefore p=0, y=0 and r=1

Taylor’s rule has some shortcomings, particularly considering times of recession; it seems Taylor rule relies heavily on estimates pegged on the potential outputs, which are not clear considering the policy of the central banks (Mishkin, 2009). Taylor rule fails to account on missed or failed inflation rates, this in return influences the price level indeterminate hence compromising future decisions and nominal contracts, central bank is left with ineffective tool that can reverse cases of deflation, central bank is left with little options in managing high inflation rates and that central bank ignores minute deviations which present a major problem in the long run. Taylors rule fails to allow convexity considering Phillips curve in the short run and that Taylor rule has a capability of prescribing an interest rate that is zero, a move that is impossible in the real sense (Bis.org, 2012).

References

Bernanke, B. S. (2013). The Federal Reserve and the Financial Crisis. Princeton, New Jersey: Princeton University Press.

Bis.org. (2012). Monetary policy and the crossroads. Retrieved September 03, 2013, from Bis.org: http://www.bis.org/publ/arpdf/ar2013e6.pdf

Blinder, A. S. (2009). Central Banking in Theory and Practice. Cambridge, Massachusetts: The MIT Press.

Koenig, E. F. (2012). The Taylor Rule and the Transformation of Monetary Policy. Stanford, California: Hoover Institution Press.

Mishkin, F. S. (2009). Monetary Policy Strategy. Cambridge, Massachusetts: The MIT Press.