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International monetary policy: a global Taylor rule.

Article Excerpt
Abstract

John Taylor's rule for setting interest rates provides a framework for studying the global monetary policy generated by individual countries pursing their own policy goals. The study reflects the global nature of monetary policy by modeling an aggregate short-term interest rate as a function of measures of worldwide inflation and the GDP gap. Multiple specifications are estimated to correspond to past studies of the U.S. relationships between these variables. The authors find that Taylor rule is a useful tool for characterizing the global monetary environment as his equation provides a good fit to the data in every specification explored by the authors. However, the international response to inflation is slightly less robust despite claims of inflation targeting by the bulk of the larger economies in the sample. (JEL F33)

Introduction

As each country pursues its monetary agenda, what is the nature of the resulting global monetary policy? Applying John Taylor's rule for setting interest rates helps to answer this critical policy question. The "Taylor Rule" presents the Federal funds rate as a simple linear function of the inflation rate and the GDP gap [Taylor, 1993]. Researchers have taken his simple rule, which prescribes policy, and used multiple regression techniques to estimate what weights the monetary authorities actually use in setting interest rates. They find that the rule's recommendations have come very close to the actual policies pursued by the Fed in the recent past [Taylor, 1993; Judd and Rudebusch, 1998]. Earlier monetary regimes followed far different paths [Spencer and Huston, 2002].

The formulation of monetary policy has become increasingly complicated. The relaxation of restrictions on the flow of money among countries has made the monetary policies of individual countries more interdependent. Thus, the three variables in Taylor's Rule are now less under the control of individual countries. For example, when capital flows are unfettered, interest rates around the world tend to move together [van der Ploeg, 1995]. As a result, efforts to unilaterally change U.S. policy rates become more difficult. Inflation, too, can be a shared experience as monetary expansion in one country spills over into other countries [Hamada, 1985]. (1) The GDP gap is also affected by the policies of other countries. For example, U.S. monetary policy clearly affects the GDP gaps of its major trading partners.

The study presented here reflects the global nature of monetary policy by modeling an aggregate short-term interest rate as a function of measures of worldwide inflation and the GDP gap. The results facilitate judgments about the implicit monetary policies of the world. That is, as each country pursues its own monetary agenda, what is the nature of the aggregate monetary policy that is produced? This is a critical question for monetary policy making. Since a country's actions have spillover effects for other countries, it is not clear that uncoordinated monetary policies produce optimal worldwide results.

Replicating U.S. studies at the international level demonstrates that the Taylor Rule is a useful tool for characterizing the global monetary environment as his equation provides a good fit to the data in those specifications explored by the authors. At the world level, however, the aggregate of central banks reacts less to inflation than does the Federal Reserve. The inflation target may have become more important to central banks, in total, in the 1990s but the evidence is not strong.

Background

"Globalization" is a term that has found great currency in recent years, generally advanced in a positive context by the political leaders and central bankers of large countries in contrast to the negative views espoused by representatives of environmental organizations, large country unions, and various rights groups. With the rise of the North American Free Trade Agreement, the European Union and a general decline in trade and financial barriers, the economies of the world have become increasingly interrelated. Even the U.S., one of the countries least dominated by world trade matters, has seen its ratio of imports relative to GDP rise from 5.4 percent in 1970 to 14.1 percent in 2003.

Financial markets have become far more integrated than earlier in consonance with international advancements in information technology and security market sophistication. Associated reductions in transactions costs have enhanced the efficient allocation of capital resources. (2)

At the same time, more countries have moved to link their currencies (and their economic fate) and to specify more...

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