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Inflation Persistence and the Taylor Rule

Inflation Persistence and the Taylor Rule. Christian Murray, David Papell, and Oleksandr Rzhevskyy. motivation. Inflation persistence is central to macroeconomics Standard New Keynesian model My favorite example – Taylor’s staggered contracts macro model

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Inflation Persistence and the Taylor Rule

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  1. Inflation Persistence andthe Taylor Rule Christian Murray, David Papell, and Oleksandr Rzhevskyy

  2. motivation • Inflation persistence is central to macroeconomics • Standard New Keynesian model • My favorite example – Taylor’s staggered contracts macro model • No trade-off between the level of inflation and the level of output (natural rate hypothesis) • Trade-off between output variability and inflation persistence

  3. motivation • We normally measure persistence through estimating autoregressive/unit root models • Unit root – shocks are permanent • Stationary – shocks dissipate over time • Measure persistence through half-lives • What do we know about unit roots and inflation?

  4. answer - not much

  5. main idea • Suppose that the empirical evidence is correct • Inflation is sometimes stationary and sometimes has a unit root • Nonsensical statement for most macro variables • Real variables • Real GDP, real exchange rates • Theory predicts either stationary or unit root

  6. main idea • Nominal variables • Nominal exchange rates, nominal interest rates, stock prices • Market efficiency arguments for unit root • Inflation is a policy variable • Milton Friedman, “Inflation is everywhere and always a monetary phenomenon” • Monetary policy can change over time

  7. main idea • Textbook macro model • Taylor rule, IS curve, and Phillips curve • Inflation persistence depends on Fed’s policy rule • δ is the key variable – chosen by the Fed • Inflation is stationary if the Taylor rule obeys the Taylor principle

  8. econometric model • A typical models used to pick policy changes in time is the Markov Switching Model • Throughout the paper, we assume • 2 states of nature • First-order Markov switching process • We start with looking at the inflation series alone, then move towards Taylor rule estimation

  9. the ms-ar(p) model • We start from looking at inflation series alone, and estimate ADF-type regression with state-dependent parameters • Inflation is constructed using the GDP deflator with quarterly data • Setup

  10. the ms-ar(2) model: results

  11. the ms-ar(2) model: states

  12. the ms-taylor rule model • We take into account • interest rate smoothing • real-time GDP data with a quadratic trend • deviations from trend are constructed using only past data • synchronization of information flows • the quarterly interest rate is the last month’s FFR

  13. the ms-taylor rule: setup • Markov specification of the Taylor rule • R* - the equilibrium real interest rate - assumed to be fixed at 2% • ω – the GDP gap parameter – is the same in both states • δ – inflation parameter – is allowed to switch; so can the target inflation rate π*

  14. the ms-taylor rule: results

  15. the ms-taylor rule: states

  16. the ms-taylor rule: robustness • Robust to: • various assumptions about the GDP gap • linear trend • stochastic trend with BN decomposition • Not robust to: • middle-period FFR instead of end-of-the-period • Standard linear or quadratic, instead of real-time, trend

  17. conclusions • There two are states for inflation • We cannot reject the unit root in one of them; the second one is stationary • Fed actions can also be characterized by two state behavior • The Taylor Rule model with Markov switching fits the data well

  18. conclusions • The 1960s, 1980s, and 1990s • Inflation stationary and the Taylor rule obeys the Taylor principle • The 1950s and 1970s • Inflation has a unit root and the Taylor rule does not obey the Taylor principle • Consistent with other evidence for the 1970s • Interest rate ceilings in the 1950s

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