Now and always, the relevance of the Taylor rule in Europe

• Published date: 01 January 2018
• Author: Agustín Díaz,Rodrigo Caputo
• DOI: http://doi.org/10.1002/ijfe.1601
• Date: 01 January 2018

Received: 26 October 2017 Accepted: 12 December 2017

DOI: 10.1002/ijfe.1601

RESEARCH ARTICLE

Now and always, the relevance of the Taylor rule in Europe

Rodrigo Caputo1Agustín Díaz2

1University of Chile MAE

2University of Pennsylvania

Correspondence

Rodrigo Caputo, University of Chile MAE.

Email: rcaputo@fen.uchile.cl

JEL Classification: E5, E52, E58

Abstract

We find that, after the adoption of the euro, the European Central Bank has

followed a forward-looking Taylor rule. This rule is such that nominal as well

as real short-term interest rates increase in response to higher expected infla-

tion or decline in output. Our findings show that the European Central Bank

policy responses are of the same magnitude and sign as the ones prevailing in

the pre-euro era for Germany, France, and Italy. We conclude that, before and

after the euro, central banks in Europe have adopteda proactive stance towards

controlling inflation.

KEYWORDS

Euro area, European Central Bank, Taylorrules

1INTRODUCTION

On January 1, 1999, the European Central Bank (ECB)

assumed responsibility for conducting monetary policy in

the euro area. The explicit policy objective was to maintain

inflation below, but close to, 2%over the medium term.

As of September 2016, the average inflation rate, since the

adoption of the euro, was 1.7%, so based on this metric,

the ECB has succeeded in its main objective. This has hap-

pened in a context in which the euro area's GDP, excluding

the financial crisis of 2008–2009, grew on average 1.6%

between 1999 and 2016.

When the European monetary union (EMU) was estab-

lished, there were several questions regarding the way in

which the newly established ECB would be setting its pol-

icy instrument, the short-term interest tentative answers

were provided in two influential papers. On the one hand,

Taylor (1999) suggested, in the context of a multicountry

model for the EMU, that simple Taylor rules could be both

efficient and robust as a guideline for the ECB. On the

other hand, Gerlach and Schnabel (2000) concluded that if

the ECB were to conduct monetary policy using the policy

rule suggested by Taylor (1993), it would not deviate from

past (weighted) interest rate setting behaviour in the EMU

countries.

In subsequent years, several contributions shed some

light on the way the ECB actually sets its policy rate since

2000. Hayo and Hofmann (2006), using monthly data from

1999 to mid-2003, compare the ECB's conduct of mon-

etary policy with that of the Bundesbank. In doing so,

they follow Clarida, Galí, and Gertler (1998) and esti-

mate forward-looking monetary policy reaction functions

for both central banks. The main conclusion is that the

ECB reacts similarly to expected inflation but significantly

stronger to the output gap than the Bundesbank did.

Gerlach (2011) estimates a reaction function for the

ECB using an ordered logit model for the period 1999 to

2009 using a policy specification in which the ECB reacts

to contemporaneous inflation, hence, departing from the

forward-looking specification used in Clarida et al. (1998)

and Hayo and Hofmann (2006). In this context, Gerlach

(2011) finds that inflation is insignificant and interprets

this as indicating that most of the variation of inflation was

due to price level shocks of little significance for monetary

policy.

In a different contribution, Gerlach and Lewis (2014)

explore whether the ECB's interest rate setting behaviour

changed during the financial crisis by estimating reac-

tion functions over the period 1999 to 2010. In doing so,

they again depart from Clarida et al. (1998) and Hayo and

Int J Fin Econ. 2018;23:41–46. wileyonlinelibrary.com/journal/ijfe Copyright© 2018 John Wiley & Sons, Ltd. 41