Scandinavian Working Papers in Economics

Working Paper Series,
Uppsala University, Department of Economics

No 2005:14: Interest Rate Smoothing versus Serially Correlated Errors in Taylor Rules: Testing the Tests

Peter Welz () and Pär Österholm ()
Additional contact information
Peter Welz: Department of Economics, Postal: Uppsala University, P.O. Box 513, SE-751 20 Uppsala, Sweden
Pär Österholm: Department of Economics, Postal: Uppsala University, P.O. Box 513, SE-751 20 Uppsala, Sweden

Abstract: This paper contributes to the recent debate about the estimated high partial adjustment coefficient in dynamic Taylor rules, commonly interpreted as deliberate interest rate smoothing on the part of the monetary authority. We argue that a high coefficient on the lagged interest rate term may be a consequence of an incorrectly specified central bank reaction function. Focusing on omitted variables, our Monte Carlo study first generates the well-known fact that all coefficients in the misspecified equation are biased in such cases. In particular, if relevant variables are left out from the estimated equation, a high partial adjustment coefficient is obtained even when it is in fact zero in the data generating process. Misspecification also leads to considerable size distortions in two tests that were recently proposed by English, Nelson, and Sack (2003) in order to distinguish between interest rate smoothing and serially correlated disturbances. Our results question the common interpretation of very slow partial adjustment as interest rate smoothing in estimated dynamic Taylor rules.

Keywords: Monetary policy; Taylor rule; Interest rate smoothing; Serially correlated error term; Omitted variables

JEL-codes: C12; C15; E52

29 pages, March 31, 2005

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