Implications Of The Central Bank Adopting Taylor’s Interest Rate Rule To The Macro-economy

By Author: Henry Ford
Total Articles: 189
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The Taylor’s rule is a special interest rate function deployed to regulate inflation and output levels within an economy by the central bank. Since the Taylor’s rule is very simple for monetary regulation, it is most effective to regulate inflation and output levels in closed economies at its original state. However, the contemporary global society has necessitated liberation of economies, resulting frequent inflows and outflows of currencies within an economy. As a result, the conformation of the Taylor’s rule has necessitated extensions to accommodate international macro-economic factors, as a central bank measure to control monetary circulation within an economy (Ullrich 2003: 137).
According to Carstens (2004: 141), the Taylor’s rule is a special function exemplified by the response to the levels of inflation and the real output breach. Considering the original equation of Taylor on interest rates, the central bank has easily been able to regulate inflation and output within an economy, in the traditional economic setup when international transactions were not intensively introduced in domestic economies. ...
... For example, Taylor’s Rule has for long been effectively employed in Turkey as a macro-economic regulator of its output and inflation. By adopting the Taylor’s Rule, Turkey’s economy was stabilized in the year 2000, after a prolonged economic crisis in the country’s economy. In fact, the Central Bank of Turkey was sentient of the inflation targeting was not easy to be changed overnight, but rather required some time to allow the establishment of stabilization. Particularly, the Taylor’s Model has been quite useful tool as an economic stabilizer among closed economies. Taylor’s original equation is shown as, it = r*+t+0.5(t-*)+0.5(yt);
where it = central bank policy rate within a given time
r* = Equilibrium Real interest rate
t = Average inflation rate over the contemporaneous and prior three quarters
= Inflation target of the central bank
y= Output gap (100 x (real GDP-potential GDP) / potential GDP)
In the above model, the central bank policy rate is apparently changed in response to the level of inflation experienced, with regard to the targeted levels of output and inflation. In case where the level of inflation or GDP is higher than the targeted level, the central bank increases interest rates reduce the excessive supply of money within the economy. A monetary policy reaction function describes how a central bank sets its policy instrument (for example short- term interest rates) in response to the economic developments (Carstens 2004: 139). The Taylor rule as a special reaction function is characterized by the response of the interest rate to inflation and the real output gap. It is important to note that, Taylor did not hypothetically assume the econometric value of 0.5 as the weighted index of the federal bank, but rather gave it as the deviations frequently experienced between the inflation and the output within an economy (Hsing 2004: 235).
It has been revealed that, foreign influences have been impacting a lot on the targeted inflation and output levels within an economy. As a result, extended Taylor’s rule has been found significant and highly effective in realizing targeted inflation and output levels within an economy, as it incorporates exchange rates together with interest rates within the model. The incorporation of the exchange rate in the model facilitates easy forecasting the inflation rate and output level within the economy. For instance, the pegged exchange rate regime of the Chinese currency against the USD has facilitated easy forecasting of the output and inflation levels in China, resulting into effective control of monetary supply in China (Carstens 2004: 134). As a result, the economic performance of China has been credible, despite its openness. The extension of the Taylor’s rule by incorporating the exchange rate in the model can be expressed as, i = f (YGAP, PGAP, E, it-1) where
E : the exchange rate with regard to another foreign currency.
Since monetary policies are generally meant to adjust monetary tools within an economy to reach the targeted levels of inflation and output, the currently experienced economic liberations needs the central bank to encompass foreign exchange rates in its regulatory models (Ullrich 2003: 139). Under the standard monetary transmission mechanism and normal conditions, the monetary authority is supposed to raise interest rates when expectations are far above the target. This forms a basis for the extension of the Taylor’s Model to accommodate the macro-economic variances like the exchange rate among others.
It is also important to note that, other policies adopted by the central bank in dealing with inflation rate are the pegging of currency rate regime and minimum bank reserve among others, with regard to the apparent international transactions in the contemporary society. Though these other policies have been found effective, the Taylor’s rule has not only been effective, but also necessary since it is accurate in correcting inflationary and output gaps (Woodford 2002: 5). This is on the basis that, inflation and output levels are the main macro-economic parameters responsible for economic welfare or stability. Through using the Taylor’s Rule, the central bank would find it effective and easier to regulate economic productivity and inflation through regulating the interest rate in its operations. In addition, its extension to incorporate exchange rates within the domestic economic activities facilitates easy understanding of the causes of any malfunctions in the economy resulting into a more efficient monetary control system (Ullrich 2003: 140).
Through an extended Taylor’s model, interest rate smoothing will be facilitated, since the exchange rates and the current inflation will be determined to enhance easy and more efficient monetary control system. Interest rate smoothing is the act of adjusting the interest rates within the economy to enhance and facilitate controlled monetary circulation, as a measure to regulate inflation and output levels within an economy. As noted by Ullrich (2003: 135), economies experience variations in their output levels, with regard to their varying capabilities to sustain production. As a result, various yields will be experienced within an economy depending on the level of money is supply within an economy.
Further, Taylor’s Model has been found quite useful in the central bank monetary policy, as it easily conforms to calibrated macro-economic model. Taylor assumed that the weights central bank ( Federal Reserve Bank) gave to deviations of inflation and output were both equal to 0.5; thus, for example, if inflation were 1 percentage point above its target, the central bank would set the real funds rate 50 basis points above its equilibrium value (Carstens 2004: 142). Furthermore, in the original Taylor formula, target inflation rate ( ) is assumed to be 2 percent per year and the equilibrium real interest rate is attributed to be 2 percent. Also remember that it= (rt + ). On this basis, Taylor’s Model can largely be dependable in solving closed economic monetary problems, since its ability to conform to calibrated economic models (Carstens 2004: 136).

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