Taylor-Type Rules versus Optimal Policy in a Markov-Switching Economy
NIPE and University of Minho
GEMF and Faculty of Economics of the University of Coimbra
Department of Economics, University of Surrey, UK and NIPE-UM
We analyse the effect of uncertainty concerning the state and the nature of asset price movements on the optimal monetary policy response. Uncertainty is modeled by adding Markov-switching shocks to a DSGE model with capital accumulation. In our analysis we consider both Taylor-type rules and optimal policy. Taylor rules have been shown to provide a good description of US monetary policy. Deviations from its implied interest rates have been associated with risks of financial disruptions. Whereas interest rates in Taylor-type rules respond to a small subset of information, optimal policy considers all state variables and shocks. Our results suggest that, when a bubble bursts, the Taylor rule fails to achieve a soft landing, contrary to the optimal policy.
JEL Classification: E52, E58.
Keywords: Asset Prices, Monetary Policy, Markov Switching.