Non Linearities in Taylor Rules - Causes, Consequences and Evidence

Abstract

The last decade has witnessed the development of an academic literature that tries to characterize and quantify monetary policy choices by central bankers or, in more technical language, to formulate and estimate the reaction function of policymakers. Following a long economic tradition such reaction functions are conceptualized as arising from an attempt by policymakers to maximize their objectives subject to a given economic structure. An early, well known illustration of this approach is the Kydland and Prescott (1977), Barro and Gordon (1983) (KPBG in the sequel) example in which policymakers possess target levels of output and of inflation and, in which, any deviation of output and of inflation from those targets is costly for them. In the KPBG framework (as well in most of the work on reaction functions till the early nineties) the relevant economic structure is based on the expectations augmented Phillips curve in which the deviation of output from its natural level is an increasing function of unexpected inflation. In those formulations central banks are assumed to directly control the rate of inflation or the money supply. ∗Berglas School of Economics, Tel-Aviv University and CEPR. e-mail: alexcuk@post.tau.ac.il

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