Understanding Monetary policy Rules: Taylor Rule Revisited

Abstract

John Taylor’s seminal work on the econometric analysis of the Federal Reserve was motivated by a desire to understand how central banks can make policy decisions in the presence of incomplete information and uncertain economic relationships. Through his analysis, Taylor found that a rules-based approach to monetary policy delivers optimal outcomes in an economy with rational expectations. While it is not possible to design an algebraic rule that can be followed across different economies and monetary systems, the Taylor rule can be a useful benchmark for analysing central bank behaviour.

We thus use the Taylor rule as a starting  point to inform our analysis on central bank independence across different geographies with contrasting economic systems, macroeconomic fundamentals and monetary systems. We perform OLS regression for ten countries using several decades of time series data to find how central banks responded to inflation and output gaps. We then use the regression results to draw conclusions about the degree of central bank independence in these nations.