Understanding the Deviations of the Taylor Rule: A New Methodology with an Application to Australia

Abstract

This investigation aims to explain and quantify the deviations of the Taylor Rule. A novel three-step econometric procedure designed to reflect the data-rich environment in which central banks operate is proposed using information for 229 macroeconomic series. This procedure can be applied to data for any economy with inflation targeting monetary rule. Our application with Australian data shows that approximately 65% of Australia’s deviation from the Taylor Rule can be explained systematically, with international factors and a domestic factor accounting for 41.9% and 22.5% respectively of the total variation in deviation from the rule. Australian deviation from the Taylor Rule is also associated with the deviation of the US´s Taylor Rule, indicating that the Reserve Bank of Australia appears to be following an international monetary policy trend set forth by the world’s largest economy.

Keywords: Taylor Rule, Monetary Policy, Small Open Economy

JEL Classification: E40, E52, E50