CHAPTER SECTION

Inter-temporal prices and interest rates

Inter-temporal prices and interest rates

Taylor Rules

In 1993, John B. Taylor proposed a theory for the monetary authorities to apply a policy rule that would help to stabilize real output around a target and control inflation. Their policy rule is based on a nominal interest rate, when real GDP and the inflation rate exceeds its target, increases to generate an increase in real interest rates and reduce aggregate demand. Conversely, if inflation and real GDP fall below the target, it is recommended to cut the nominal interest rate so that aggregate demand can be increased by means of an increase in real interest rate. Thus, according to Taylor, the short term nominal interest rate should be an increasing function of inflation and real output for given objectives in both variables (Taylor 2005, 28).

Keynesian models designed to evaluate the performance of the Taylor rule set consists of equations for aggregate demand and inflation. The structure of interest rates and the rule of interest rate policy that connects the interest rate on short-term deviations of inflation and real output of its goals. The role of aggregate demand is a function that takes the form of IS. The equation for inflation arises from a context that assumes the existence of wage contracts that are set in different times. It leads to the inflation rate that is a function of contemporary, past inflation rates, than expected for the contract periods, and the output gap. According to Taylor, there are many issues related to the design of the policy rule and model specification that require further study (Taylor 2003, 78).

The policy rule assigns weights to deviations of inflation and real output from its target values to determine the response of the nominal interest rate. The linear rule recommended by Taylor policy should be viewed as the result of minimizing a quadratic loss function whose arguments are the deviations of the interest rate and real output values defined as a goal. As noted by Robert Lucas in 2003, the question is to find out what are the benefits for an economy to stabilize real output and inflation holding at low levels. The estimates are based on a theoretical model in which the decisions of a consumer representative on eating today or consume in the future are taken as consumer expectations about future real income. Thus, fluctuations in consumption patterns are often compared to the real income throughout the economic cycle, because consumption decisions are based on the present value of expected future real income, rather than current income.

Different economist believes that there is a benefit to the economy where consumption is stabilized. Their estimates suggest that profits obtained by stabilizing changes in consumption is equal to about one tenth of one percent of private consumption. On the other hand, the cost of inflation is more or less equivalent to one percent of private consumption. Therefore, an economist Lucas suggests that while formulating macroeconomic stabilization policies, there should be a constant level to stabilize ...