TARGETS IN THE TAYLOR RULE: INFLATION, SPEED LIMIT, OR PRICE LEVEL?

Authors

  • PAVEL KAPINOS,

    1. Kapinos: Assistant Professor of Economics, Department of Economics, Carleton College, Northfield, MN 55057. Phone (507) 222-7676, Fax (507) 222-4044, E-mail pkapinos@carleton.edu
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  • MICHAEL S. HANSON

    1. Hanson: Senior Economist, Bank of America Merrill Lynch Global Research, One Bryant Park, New York, NY 10036. Phone (646) 855-6854, E-mail michael.s.hanson@baml.com
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    • The views expressed herein are those of the authors and do not necessarily reflect those of Bank of America Merrill Lynch. The authors would like to thank the participants of the 2009 Western Economic Association meetings and 2009 Midwestern Econometric Group meeting for feedback on the preliminary version of this paper and three anonymous referees and the editor for valuable suggestions that have improved the paper. All remaining errors are our own.


Abstract

This paper explores the link between alternative targets in the Taylor rule and their empirical fit using real-time U.S. macroeconomic data. We first study the stabilizing properties of the classical Taylor rule (inflation targeting, IT) and add either a price-level target (PLT) or output gap quasigrowth target (speed-limit targeting, SLT) in the context of the standard New Keynesian model. We demonstrate that, although only SLT has the same functional form as the optimal interest-rate reaction function, both PLT and SLT stabilize the model macroeconomy against a cost-push shock for a wide range of parameter values better than IT. We then estimate all three specifications using the Greenbook data. We find much stronger support for SLT than PLT and discuss pitfalls in estimating the latter that are present in existing literature. (JEL E52, E58)

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