Belke, Ansgar; Klose, Jens:

Modifying Taylor Reaction Functions in Presence of the Zero-Lower-Bound - Evidence for the ECB and the Fed

In: DIW Diskussionspapiere = Discussion Papers / Deutsches Institut für Wirtschaftsforschung, (2012) ; Nr. 1218, S. 1-33
ISSN: 1433-0210
Zeitschriftenaufsatz / Fach: Wirtschaftswissenschaften
Fakultät für Wirtschaftswissenschaften » Fachgebiet Volkswirtschaftslehre » Makroökonomik
We propose an alternative way of estimating Taylor reaction functions if the zero-lowerbound
on nominal interest rates is binding. This approach relies on tackling the real rather
than the nominal interest rate. So if the nominal rate is (close to) zero central banks can
influence the inflation expectations via quantitative easing. The unobservable inflation
expectations are estimated with a state-space model that additionally generates a timevarying
series for the equilibrium real interest rate and the potential output - both needed
for estimations of Taylor reaction functions. We test our approach for the ECB and the Fed
within the recent crisis. We add other explanatory variables to this modified Taylor reaction
function and show that there are substantial differences between the estimated reaction
coefficients in the pre- and crisis era for both central banks. While the central banks on both
sides of the Atlantic act less inertially, put a smaller weight on the inflation gap, money
growth and the risk spread, the response to asset price inflation becomes more pronounced
during the crisis. However, the central banks diverge in their response to the output gap and
credit growth.