How is the Taylor Rule Distributed under Endogenous Monetary Regimes?

• Author: Xiaochun Liu
• Date: 01 June 2018
• Published date: 01 June 2018
• DOI: http://doi.org/10.1111/irfi.12131

How is the Taylor Rule Distributed

under Endogenous Monetary

Regimes?

XIAOCHUN LIU

The Department of Economics, Finance & Legal Studies, Culverhouse College of

Commerce, University of Alabama, Tuscaloosa, AL, USA

ABSTRACT

This paper estimates Taylor rules at various points (quantiles) on the

conditional interest-rate distribution for endogenously identified monetary

regimes. I find that the Taylor principle upholds only for the upper tails of

the interest-rate distribution in monetary Hawkish regimes, but not in

monetary interim and Dovish regimes. Moreover, the results show that the

Federal Reserve responds more aggressively to inflation at upper tails than at

lower tails in both monetary Dovish and Hawkish regimes, implying its

significant inflation-avoidance preference. Finally,the Federal Reserve appears

to respond to inflation more aggressively during Hawkish regimes than during

Dovish regimes across quantiles.

I. INTRODUCTION

Recent studies with evidence of nonlinear monetary policy have challenged the

exclusively estimated linear Taylor rule. One of the important nonlinearities is

possible regime shifts in future monetary policy. Current literature often treats

monetary policy shifts as once-and-for-all rather than an ongoing process. This

is logically inconsistent with the rational expectations view as agents form

expectations based on all available information, including possible changes in

future policy (Davig and Leeper (2007) and Liu et al. (2009)). Knowing the

practical importance of regime change, rational agents should ascribe a

probability distribution to possible policy shifts in the future. In this regard,

Murray et al. (2015) among others estimate a forward-looking Taylor rule with

endogenous Markov-switching coefficients and variances, and the authors find

that imposing monetary regimes exogenously based on different Federal Reserve

chairmanships is generally misleading.

However, the studies in this direction focus typically on switching monetary

regimes at the conditional mean and in some cases, the conditional variance.

This, nonetheless, is an incomplete description of monetary policy reactions

especially when the Taylor rule is not uniformly distributed over the conditional

interest-rate distribution. For instance, interest rates may largely deviate from the

© 2017 International Review of Finance Ltd. 2017

International Review of Finance, 2017

DOI: 10.1111/irfi.12131

International Review of Finance, 18:2, 2018: pp. 305–316

DOI:10.1111/irfi .12131

© 2017 International Review of Finance Ltd. 2017