Castro, Vítor Manuel Alves (2008) Are Central Banks following a linear or nonlinear (augmented) Taylor rule? Working Paper. University of Warwick, Department of Economics, Coventry.

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Abstract

The Taylor rule establishes a simple linear relation between the interest rate, inflation and output gap. However, this relation may not be so simple. To get a deeper understanding of central banks’ behaviour, this paper asks whether central banks are indeed following a linear Taylor rule or, instead, a nonlinear rule. At the same time, it also analyses whether that rule can be augmented with a financial conditions index containing information from some asset prices and financial variables. A forward-looking monetary policy reaction function is employed in the estimation of the linear and nonlinear models. A smooth transition model is used to estimate the nonlinear rule. The results indicate that the European Central Bank and the Bank of England tend to follow a nonlinear Taylor rule, but not the Federal Reserve of the United States. In particular, those two central banks tend to react to inflation only when inflation is above or outside their targets. Moreover, our evidence suggests that the European Central Bank is targeting financial conditions, contrary to the other two central banks. This lack of attention to the financial conditions might have made the United States and the United Kingdom more vulnerable to the recent credit crunch than the Eurozone.

Item Type:	Working or Discussion Paper (Working Paper)
Subjects:	H Social Sciences > HG Finance
Divisions:	Faculty of Social Sciences > Economics
Library of Congress Subject Headings (LCSH):	Bank of England, European Central Bank, Federal Reserve banks, Taylor's rule, Monetary policy -- Mathematical models, Regression analysis -- Mathematical models, Nonlinear theories
Series Name:	Warwick economic research papers
Publisher:	University of Warwick, Department of Economics
Place of Publication:	Coventry
Date:	September 2008
Number:	No.872
Number of Pages:	45
Status:	Not Peer Reviewed
Access rights to Published version:	Open Access
Funder:	Fundação para a Ciência e a Tecnologia (FCT)
Grant number:	SFRH/BD/21500/2005 (FCT)
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URI:	http://wrap.warwick.ac.uk/id/eprint/1344

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