Markov Switching and the Taylor Principle

24 Pages Posted: 6 Aug 2013

See all articles by Christian J. Murray

Christian J. Murray

University of Houston - Department of Economics

Alex Nikolsko‐Rzhevskyy

Lehigh University - Business School

David H. Papell

University of Houston - Department of Economics

Date Written: August 5, 2013

Abstract

Early research on the Taylor rule typically divided the data exogenously into pre-Volcker and Volcker-Greenspan subsamples. We contribute to the recent trend of endogenizing changes in monetary policy by estimating a real-time forward-looking Taylor rule with endogenous Markov switching coefficients and variance. The response of the interest rate to inflation is regime dependent, with the pre and post-Volcker samples containing monetary regimes where the Fed did and did not follow the Taylor principle. While the Fed consistently adhered to the Taylor principle before 1973 and after 1984, it followed the Taylor principle from 1975-1979 and did not follow the Taylor principle from 1980-1984. We also find that the Fed only responded to real economic activity during the states in which the Taylor principle held. Our results are consistent with the idea that exogenously dividing postwar monetary policy into pre-Volcker and post-Volcker samples misleading. The greatest qualitative difference between our results and recent research employing time varying parameters is that we find that the Fed did not adhere to the Taylor Principle during most of Paul Volcker’s tenure, a finding which accords with the historical record of monetary policy.

Keywords: Taylor principle, Markov switching

JEL Classification: E52, E58

Suggested Citation

Murray, Christian J. and Nikolsko-Rzhevskyy, Alex and Papell, David H., Markov Switching and the Taylor Principle (August 5, 2013). Available at SSRN: https://ssrn.com/abstract=2306295 or http://dx.doi.org/10.2139/ssrn.2306295

Christian J. Murray

University of Houston - Department of Economics ( email )

Houston, TX 77204-5882
United States

Alex Nikolsko-Rzhevskyy (Contact Author)

Lehigh University - Business School ( email )

621 Taylor Street
Bethlehem, PA 18015
United States

HOME PAGE: http://www.nikolsko-rzhevskyy.com

David H. Papell

University of Houston - Department of Economics ( email )

Houston, TX 77204-5882
United States