Taylor Rule Deviations and Financial Imbalances

Abstract

Over the last quarter century, the U.S. economy has faced a number of financial shocks originating in a variety of sectors and locations around the globe. While most of these crises have had little or no effect on the United States, the recent financial crisis caused the worst U.S. recession since the Great Depression. ; The causes of these crises are varied. To some extent, however, a buildup of financial imbalances preceded each crisis. In some cases, asset prices rose to unsustainable levels inconsistent with market fundamentals. In other cases, a buildup of foreign debt precipitated a currency crisis. A key question for policymakers is whether policy actions taken in the period leading up to the crisis leaned against, or contributed to, the building imbalances. ; Kahn explores whether policy actions taken in the period leading up to the recent financial crisis inadvertently exacerbated financial imbalances by keeping policy-controlled interest rates too low for too long. He uses deviations from Taylor rules as indicators of interest rates being held too low and considers a number of indicators of financial imbalances. While there appears to be a statistically significant relationship between Taylor rule deviations and a number of financial indicators, their economic significance is mixed.

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