The Use and Abuse of Taylor Rules: How Precisely Can We Estimate them?

Abstract

This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate. This paper draws attention to inconsistencies in estimating simple monetary policy rules and their implications for policy advice. We simulate a macroeconomic model with a backward reaction function similar to Taylor (1993). We estimate different versions of a policy rule, using these simulated data. Under certain circumstances, estimations document an illusionary presence of a lagged interest rate, or of forward-looking behavior. Our results are consistent with the fact that several authors found very different versions of monetary policy rules, all fitting the U.S. data well. We also survey the literature, providing a list of issues complicating practical use of Taylor rules.