Research Papers

On the Taylor Rule and Optimal Monetary Policy in a “Natural Rate” Model

Date: 05/11/2015Author: George Alogoskoufis 0 Comments

This paper investigates the stabilizing role of monetary policy in a dynamic, stochastic general equilibrium model of the “natural rate”, in which non indexed nominal wages are periodically set by labor market “insiders”.

This nominal distortion allows for nominal shocks to have temporary real effects, and thus, for monetary policy to be able to affect short run fluctuations in both inflation and real output.

We derive and analyze optimal monetary policy in the presence of real and nominal shocks, and highlight the properties of the optimal monetary policy rule.

The optimal policy rule is second best, as it cannot completely neutralize productivity shocks, and is associated with a tradeoff between the stabilization of inflation and output.

We also demonstrate that the optimal policy can be replicated by a set of appropriately parametrized Taylor rules, according to which deviations of the current nominal interest rate from its “natural” rate, depend on deviations of inflation from target and output from its “natural” level.

We prove that the optimal Taylor rule is not unique, as multiple sets of parameters are consistent with optimality.

Provided that the monetary authorities attach a sufficiently low weight to deviations of output from its “natural” level, the optimal policy could also be replicated through a unique, appropriately parametrized Wicksell rule, according to which deviations of the nominal interest rate from its “natural” rate depend only on deviations of inflation from target.

The optimal set of Taylor rules is a set of simple, but not too simple rules, as, the nominal interest rate must react to changes in the “natural” rate of interest, in addition to deviations of inflation from target, and output from its “natural”level.

Discussion Paper no. 5-2015, Department of Economics, Athens University of Economics and Business

PDF of Updated Paper, April 2016

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The origins of the post-2010 Greek crisis and the pre-conditions – economic, political and institutional - for a sustained recovery of the Greek economy were examined recently by a number of prominent academics, many of whom possess extensive political experience in Greece. A selection of their contributions, first presented in a workshop at the London School of Economics, in December 2018, and a conference at the Fletcher School of Tufts University in April 2019, is collected in this e- book, edited by the organisers, George Alogoskoufis and Kevin Featherstone. With ramifications for both Greece and the Euro-Area as a whole, the contributions consider the constraints that derive from the structural linkages between the domestic and the European levels. While concerned with the core economic agenda, they place it within its political, social, and institutional contexts in order to have a more complete assessment. They ask what scope there is for recovery, the priorities that need to be set, and the prospects for their attainment. Many of the chapters have been updated to take into account developments since the Covid-19 pandemic in 2020. More details on the 2018 workshop and the 2019 conference that led to this e-book can be found in the link below.

This book from the Centre for Economic Policy Research (CEPR) deals with the implications of the exchange rate regimes and capital flows of the 1990s for government macroeconomic policy-making and EC policy co-ordination. Under the fixed exchange rates of the 1950s, economists and policy-makers had a much clearer idea of the nature of the external constraints. The commitment to defending the exchange rate is stronger in the 1990s than in the 1970s and 1980s, but at the same time international capital flows are far greater and freer than in the 1950s and 1960s, with many countries able to borrow almost indefinitely and on good terms on the Eurodollar market in order to finance their balance-of-payments deficits. This volume, derived from a conference organised jointly by CEPR and the Bank of Greece, deals with these issues in depth and includes both cross-country comparisons and case studies of individual countries.

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