(a) Briefly outline the economic reasoning behind the Taylor principle, and comm
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Question
(a)
Briefly outline the economic reasoning behind the Taylor principle, and comment on the influence of this principle in monetary policy formation.
(b)
Based on your readings, do you believe that Central Banks should tackle asset bubbles so as to minimise negative spillovers to the real economy? Explain your answer.
(a)
Briefly outline the economic reasoning behind the Taylor principle, and comment on the influence of this principle in monetary policy formation.
(b)
Based on your readings, do you believe that Central Banks should tackle asset bubbles so as to minimise negative spillovers to the real economy? Explain your answer.
Explanation / Answer
Definitation of Taylor Rule
A principle used in the management of Interest rate.
This refers to a rule used by central banks to determine the right interest rate for the economy based on changes in price inflation and other economic conditions. It was proposed by American economist John Taylor as a tool to conduct rules-based monetary policy. The Taylor rule is often proposed as a solution to the problem of discretion involved in the framing of monetary policy due to the influence of political populism. It provides a formula to determine how much a central bank should target an increase or decrease in interest rates depending on the economy’s health.
Key Factors of the Taylor Rule
The Taylor rule is based upon three factors:
Formula
Where,
Target rate is the short-term interest rate which the central bank should target;
Neutral rate is the short-term interest rate that prevails when the difference between the actual rate of inflation and target rate of inflation and difference between expected GDP growth rate and long-term growth rate in GDP are both zero;
GDPe is expected GDP growth rate;
GDPt is long-term GDP growth rate;
Ie is expected inflation rate; and
It is target inflation rate
Influence of Taylor Rule in Monetary Policy Formation
John Taylor has argued that his rule should prescribe as well as describe a benchmark for monetary policy. Rule-based systems for monetary policy have some clear advantages. First, they increase transparency and predictability, helping the central bank explain its actions to the public, and assisting the market in predicting what the Fed will do. Monetary policy has a powerful impact on people’s lives – low interest rates benefit debtors at the expense of creditors, for example. Because market observers spend a huge amount of resources trying to anticipate what the Fed will do and plan accordingly, having a clear rule-based system saves a lot of collective time and money. Monetary policy rules can also increase the accountability and credibility of future policy actions. Think of this as committing to a diet: Setting rules helps to reduce the incentive to later renege on one’s promises, especially if others are watching. In a country without such a rule-based system, the argument goes, a central bank could promise to keep inflation low, but then later be tempted into printing money to generate revenue for the government.
b] Central Banks should tackle asset bubbles so as to minimise negative spillovers to the real economy
The historical evidence suggests that the emergence of bubbles is often preceded or accompanied by an expansionary monetary policy, lending booms, capital inflows, and financial innovation or deregulation. We find that the severity of the economic crisis following the bursting of a bubble is less linked to the type of asset than to the financing of the bubble crises are most severe when accompanied by a lending boom and high leverage of market players, and when financial institutions themselves are participating in the buying frenzy. Past experience also suggests that a purely passive “cleaning up the mess” stance toward the buildup of bubbles is, in many cases, costly. Monetary policy and macroprudential measures that lean against inflating bubbles can and sometimes have helped deflate bubbles and mitigate the associated economic crises. However, the correct implementation of such proactive policy approaches remains fraught with difficulties. First, bubbles cannot be identified with confidence. They appear to be a problem especially in combination with unstable financial institutions or markets. Therefore, bubbles should be tackled by financial regulation.when asset prices experience a bubble it should be a matter of concern for the central bank because the bubble will be followed by a crash, and that is when the balance sheet of the central bank will be affected. We can see there is a history of bubble episodes which has eventually lead to severe economic crisis situations. Asset-price bubbles have negative effects on the economy.The departure of asset prices from fundamentals can lead to inappropriate investments that decrease the efficiency of the economy.
Target Rate = Neutral Rate + 0.5 × (GDPe GDPt) + 0.5 × (Ie It)Related Questions
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