Can the Taylor rule be a good guidance for policy? The case of 2001–2008 real estate bubble

Abstract

John Taylor (2009) argues that if the Federal Reserve had followed his famous monetary-policy rule, the severe recession that resulted from the real estate bubble could have been avoided. While one may agree with Taylor’s empirical analysis and accept his demonstration that his proposed rule would lead to a more stable economic environment, it is unclear whether central banks are capable of avoiding bubbles by simply following the Taylor rule. One can construct various Taylor rules from the data. Some of those rules model what the Federal Reserve actually did. Following the specific type of Taylor rule recommended by John Taylor would in fact amount to a better monetary policy, but only because it calls for setting interest rates higher. In the second section, we introduce Taylor rules. In the third section, we apply these rules to monetary policy since 2001. The fourth section situates the Taylor rule in the Wicksellian framework of interest rates and macroeconomic stability. In the fifth section, we discuss the effects of policy rules on macroeconomic stability.