Scandinavian Working Papers in Economics

Working Paper Series,
Uppsala University, Department of Economics

No 2003:20: The Taylor Rule: A Spurious Regression?

Pär Österholm ()
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Pär Österholm: Department of Economics, Postal: Uppsala University, P.O. Box 513, SE-751 20 Uppsala, Sweden

Abstract: This paper investigates the econometric properties of the Taylor (1993) rule applied to U.S., Australian and Swedish data to judge its empirical relevance. Little attention has been paid to the time series properties of the data underlying interest rate rules, nor the estimations themselves, despite the rise in popularity of Taylor-like rules in both empirical and theoretical work. Unit root tests indicate that the variables commonly used in such modelling are likely to be integrated of order one or near integrated. Given that the variables in the Taylor rule are integrated of order one or near integrated processes, cointegration is a necessary condition both for consistent estimation of the parameters of the model and compatibility between the model and the data. Tests find little support for cointegration and, together with an out-of-sample forecast exercise, suggest that we should have serious doubts about the Taylor rule as a reasonable description of how monetary policy is conducted in the countries considered in this study. Parameter estimates from the standard Taylor rule regressions are therefore likely to be inconsistent and caution should be taken before for central bank policy is evaluated using such methods.

Keywords: Monetary policy; Taylor rule; Cointegration

JEL-codes: E52

28 pages, August 15, 2003

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