Monetary policy rules and cointegration: An international analysis of inflation targeting

In the 1990s the central banks of many industrialized countries turned to the policy of inflation targeting. John Taylor (1993) argues that a simple, inflation targeting rule describes the Fed's policies for the period 1987--1992. This rule treats inflation and output gap as the targets and short run nominal interest rates as the instrument. If the coefficient on inflation is greater than unity, then the central bank is said to follow an inflation targeting policy, whether this is explicitly stated or not. Three problems that arise from the literature of testing whether central banks follow Taylor's rule are considered in this project. First due to the non-stationarity of at least two of the three variables, the variables are assumed to be cointegrated. Several tests are utilized to lend support to this assumption. Second, in order to correct for the serial correlation in the data, I use the Fully Modified OLS procedure. In doing this I also avoid any simultaneity issues. Third, the data are tested for structural breaks in order to avoid the subjectivity of choosing the data sample. Three countries are individually tested for Taylor's rule. The results indicate that the Fed has been following an inflation targeting policy since 1979. The policy has been output stabilizing since 1989. ECMs show a considerable degree of interest rate smoothing. Using a goodness of fit measure I also find that such a rule fits the U.S. data better for the 1960--1969 and 1989--1997 periods. For Germany I also find that a price, but not output, stabilizing policy has been followed for the period 1979--1997. The DM/ECU exchange rate is found to have small quantitative effects on the determination of interest rates. It also seems that the Bundesbank responds positively to West German output deviations only. For the U.K. a price, but not output, stabilizing policy is found for the period between 1983--1997 when the CPI is used. When the RPI is used then the policy seems to be both price and output stabilizing. German interest rates are found to be significant with a coefficient close to unity. Exchange rates are here found to have small quantitative effects on interest rates as well. ECM show that between the three countries, the U.K. has the lowest degree of interest rate smoothing.