Home | Business News | Browse by Publication | I | International Advances in Economic Research

Taylor rule in practice: Evidence from Turkey.

Article Excerpt
Abstract This paper estimates the backward-looking and forward-looking monetary policy reaction functions of the Central Bank of the Republic of Turkey (CBRT) by considering the post-crisis period from August 2001 to September 2006, with a special emphasis on inflation targeting. Policies which the CBRT applied are analyzed according to the Taylor rule. The empirical results indicate that the CBRT followed the Taylor rule in its interest setting behaviour. In forward-looking models, the response coefficient of inflation and the output gap is greater than that of backward-looking models. The results of forward-looking models reflect, the policies conducted in Turkey. In the post-crisis period, expected inflation has been the main reaction variable for the CBRT. This suggests that monetary policy over the post-crisis period was not accommodating increases in expected inflation. The main conclusion is that 'Taylor rule' based monetary policies were effective in inflation targeting in Turkey.

Keywords Turkey. Inflation targeting. Taylor rule. Monetary policy. Reaction function GMM

JEL E40

Introduction

The aim of this paper is not to take a stand in the rules versus discretion debate, but to see which if any rules characterize the actions of the CBRT. The literature on monetary policy rules can be divided into two types of instrument rules; interest rate based instrument rules and monetary based instrument rules, known as the Taylor (1993) rule and the McCallum (1988) rule. The McCallum rule defines the growth rate of the monetary base that monetary authorities should provide. The rule targets nominal GDP using the monetary base as an instrument.

McCallum (2000, p. 53) states that his rule "features responses to the same macroeconomic conditions as in Taylor's rule, but with a base instrument." In countries where short-term interest rates are used as a policy instrument, it is the Taylor rule which suggests that the monetary policy instrument should be regulated according to changes in macroeconomic conditions. In the Taylor rule, the instrument rate is a linear function of the deviations of inflation from its target and the deviations of output from its potential level. (1)

The interest setting behavior of central banks indicates significant information about the monetary policy aims of countries. Clarida et al. (1998) found that central banks in developed countries followed the Taylor rule (1993) in their interest setting behaviour. (2)

When monetary policy rules are divided into two as "non-contingent" and "state-contingent" rules, the Taylor rule seems to be in the second group. A "non-contingent" rule represents an inflexible commitment to a nominal anchor and does not allow for any sort of response to economic conditions. Friedman's rule (1960) is an example of this kind of inflexibility. According to Kuttner (2004), this kind of inflexibility arises from assigning a zero weight to output fluctuations in the central bank's loss function.

Currently, some hold that monetary policy rules must be arranged according to changes in economic conditions. Friedman and Kuttner (1996) and King (1997) state that a rigid rule does not allow monetary policymakers enough discretion to respond to unforeseen circumstances. The fact that the monetary policy rule does not respond to varying economic conditions destabilizes the real economy. Kuttner (2004) suggests that conditional rules, which enable authorities to respond to changes in economic conditions, should be employed. These rules can be divided into two categories; Taylor-type political rules relating the policy instrument to some selection of macroeconomic variables, and those derived from an explicit optimization problem as analyzed in Svensson (1999) and Rudebusch and Svensson (1999).

In practice, some believe that the use of interest rates as the main policy instrument is related to inflation targeting. As stated by Vegh (2001), authorities determine an inflation target and change interest rates in order to reach this target. Similarly, in his weak description of inflation targeting, Kuttner (2004, p. 92) defines the relationship between inflation targeting (IT) and the policy instrument as follows; "The weakest definition of IT is having some desired rate of inflation,[pi] (which need not be announced) and employing a reaction function or instrument rule that satisfies the Taylor rule."

Views differ regarding whether to describe inflation targeting as a sort of a monetary policy rule. Bernanke and Mishkin (1997), Bernanke et al. (1999) describe IT as rule-like policy strategies. As rule-like policy strategies are of a forward-looking structure, they prevent central banks from conducting policies, which may have undesirable results over the long-run. When unforeseen and unusual conditions occur in the economy, these types of policy strategies enable monetary authorities to follow discretionary policies. These intermediate approaches make the central bank to subject to constrained discretion.

In rule-like policy strategies, it has been emphasized that both price stability and real economy must...