EMPIRICAL EXAMINATION OF THE TAYLOR

RULE FOR THE UNITED STATES

Monika Bohnke (I6068362), Wiktor Owczarz (I6052598)
Bianca Vermeer (I6075302)
Macroeconomics and Economic Policy (EBC2040)
Tutor: Lennart Freitag, Tutorial 4
Word count: 2 809
Maastricht University
School of Business and Economics

April 10, 2015

Contents
1 Introduction

2 Economic Overview to the United States

2.1 Development of the output gap . . . . . . . . . . . . . . . . .
2.2 Development of the effective federal funds rate . . . . . . . .
2.3 Development of the inflation rate, GDP deflator . . . . . . . .

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3 Monetary policy goals in the United States

4 The original Taylor Rule

5 Estimating the Taylor Rule

5.1 Empirical analysis for the United States . . . . . . .
5.2 Exclusion of misspecification and spurious regression
5.2.1 Normality test . . . . . . . . . . . . . . . . .
5.2.2 Homoscedasticity . . . . . . . . . . . . . . . .
5.2.3 Spurious regression . . . . . . . . . . . . . . .
6 Conclusion

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7 Appendix
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7.1 Empirical Estimation of the Taylor Rule . . . . . . . . . . . . 19
7.1.1 Misspecification tests . . . . . . . . . . . . . . . . . . . 20
7.1.2 Spurious Regression Examination . . . . . . . . . . . . 20

Introduction
Table 1: Estimation results : regress
Variable
str
Intercept

Coefficient
-2.280
698.933

N
R2
F (1,418)
Significance levels :

(Std. Err.)
(0.519)
(10.364)
420
0.051
19.259

: 10%

: 5%

: 1%

Decisions by the Federal Reserve (central bank of the United States) have
been and will continue to be of notable national and international interest.
In effect, as the US dollar is the currency most used for worldwide transactions, many countries observe the strategic focus of monetary policy in the
United States on a regular basis. Especially the recent economic and financial crisis demanded a thorough approach. Low interest rates were needed
to stabilise and boost the American economy. Hence, the Federal Reserve
set target levels for the federal funds rate close to zero and implemented a
programme of large-scale asset purchases that should facilitate the access
to money. How extensive such quantitative easing measures should be and
how nominal interest rates should be chosen to induce the desired effects,
are nonetheless crucial questions. In particular, the latter issue mattered to
economists like John B. Taylor who formulated a monetary policy rule in
the early nineties of the last century. Taylor investigated a relationship that
describes how to set nominal interest rates depending on the natural real
rate of interest, inflation and the output gap in the United States from 1982
- 1991. He estimated a simple formula that should help to guide monetary
policy. His findings are widely known as the Taylor Rule. However, did
the Taylor Rule hold as well over a longer time span, including the latest
financial crisis?
The purpose of this paper is to elaborate whether the Taylor Rule is an
3

adequate theory to support and facilitate the decision-making processes of

the Federal Reserve. It gives a brief overview of the economic situation in the
United States and highlights the developments of the output gap, the federal
funds rate and the inflation rate over time. Further, this paper discusses
a period of disinflation initiated by Paul Volcker in 1979 and emphasises
the latest goals of monetary policy. Moreover, the original Taylor Rule is
presented and an estimation on the basis of quarterly data from 1980 - 2014
is conducted. Finally, this paper accounts for problems like misspecification
and spurious regression to justify its overall results.

2
2.1

Economic Overview to the United States

Development of the output gap

According to the latest OECD Economic Outlook, the US has been recovering from the financial crisis and has experienced an increase in economic
growth. This is mainly due to the fact that industry output is on a steady
growth path. Furthermore, net wealth of households has risen in the past
few years, partly because of increasing asset prices. Contrary to the increase
in aggregate demand, gradual fiscal contraction is taking place to ensure fiscal sustainability and even further narrowing of the federal budget deficit in
the coming years can be expected (OECD, 2014). The net effects of the development of output with respect to its natural level are depicted in Figure
1 below.

Figure 1: Development of the output gap over time

Source: Federal Reserve Economic Data.

The fluctuations around the horizontal line at 0% show the deviations

of output from its natural level. For example the low in 2010 represents a
negative output gap of approximately -3% that was due to a large decline
in aggregate demand after the financial crisis started. However, this graph
is based on estimations with the help of a Hodrick-Prescott filter, since
the natural level of output cannot be observed empirically. An interesting
feature of Figure 1 that should be highlighted is that fluctuations are overall
smaller after the mid 1980s than they were ever before. The largest decrease
in output occurred from 1979 until 1982, which resulted from a period of
disinflation that was initiated by Paul Volcker as is explained in the following
sections.

2.2

Development of the effective federal funds rate

Figure 2: Development of the federal funds rate over time.

Source: Federal Reserve Economic Data.

In Figure 2, the development of the effective federal funds rate is shown

from 1954 until 2014. The Federal Reserve targets the federal funds rate in
its monetary policy. This is the interest rate at which banks charge each
other for overnight loans of federal funds, balances held at Federal Reserve
Banks (FRED, 2014). As is shown in the graph, the interest rate had a
major peak in the 1980s. This high nominal interest level is a result of the
policies implemented by Paul Volcker, which aimed to stop the stagflation
crisis (Boivin, 2005). Afterwards, interest rates decreased gradually towards
a current level of around 0%. This is a result of the Federal Reserve policies
implemented to boost consumption and investment after the financial crisis
(Federal Reserve, 2014).

2.3

Development of the inflation rate, GDP deflator

Figure 3: Development of the GDP deflator over time

Source: Federal Reserve Economic Data.

Figure 3 presents the development of inflation (GDP deflator) over time,

starting from the third quarter of 1954 until the third quarter of 2014. The
inflation rate was on a high level throughout the 1970s, while the output
growth rate was low and the unemployment rate was high. The main cause
for the rapid increase in US inflation was the disproportionate loose monetary policy. An increase in inflation was typically associated with a smaller
increase in the nominal interest rate, which led to a lower real interest rate
(Boivin, 2005). Moreover, the oil crises had a major impact on price levels.
In 1979, the Iranian revolution led to an even further increase in oil prices
that raised inflation rates dramatically (Goodfriend & King, 2005). In the
same year, Paul Volcker was appointed as the new chair of the Federal Reserve. Inflation was above 10% by then. He started a period of disinflation
7

by first increasing the interest rates rapidly. As interest rates were increased,
investing and borrowing money became less attractive. This way the economy slowed down, output decreased and the unemployment rate increased.
This policy resulted in the early 1980s recession, which did not only affect
the US, but also other OECD nations (Goodfriend & King, 2005). However,
Volckers policy also effectively led to a decrease in inflation, as shown in
the third graph; there is a dramatic drop in the inflation rate from the third
quarter of 1980 onwards. Because of high unemployment and low output
there was a downward pressure on wages which in turn led to disinflation
(Gottfries, 2013). By the end of 1982, inflation had fallen to around 5%.
The Federal Reserve decided to manage the interest rate more closely and
to create a policy to close the output gap that had been created during the
disinflation. The interest rates were decreased, which ended the recession in
November 1982 (Goodfriend & King, 2013).

Monetary policy goals in the United States

Since 1913, the Federal Reserve has been in charge of setting monetary
policy. Besides current means to determine the discount rate and reserve
requirements, its key tools are open market operations, conducted by the
Federal Open Market Committee (FOMC). Following from the latest Statement on Longer-Run Goals and Monetary Policy Strategy, the primary
goals of monetary policy in the United States are to promote maximum
employment, stable prices and moderate long-term interest rates (Board of
Governors of the Federal Reserve System, 2014). However, not all of these
intentions are directly feasible with their given means. In effect, Gottfries
(2013) proves that monetary policy cannot influence the long-run level of
production and employment. Hence, there is no fixed goal for employment,
but still the FOMC is required to assess their decision-making with respect
to maximised employment in future periods. Concerning stable prices, they
are more explicit and announce an official target rate of 2% over the mediumterm. (Board of Governors of the Federal Reserve System, 2014). Nevertheless, this has not been the case in the past. The United States were mostly
8

said to follow an implicit target (Thornton, 2012). To actually control for

inflation, the Federal Reserve generally has two options. Since prices are
sticky in the short-run it can either determine the money supply or set the
nominal interest rate. Both are possible strategies, but the central bank of
the US decided to direct the latter, since a policy that holds money supply
constant leads to vast fluctuations in interest rates every time a shock affects money demand. This is clearly not consistent with moderate long-term
interest rates. Consequently, the FOMC uses its monetary tools to influence
the federal funds rate, which in turn affects the amount of money demand,
other short-term and long-term interest rates in the financial markets, foreign exchange rates and many other variables. The federal funds rate was
already introduced above (Figure 2) and is further used in the analysis of
the Taylor Rule as the representative interest rate of the Unites States.

The original Taylor Rule

Taylor was not the first economist that suggested a rule to facilitate monetary policy for central banks. Irving Fisher, Knut Wicksell or Milton Friedman were only a few others that proposed monetary policy rules before him.
However, Taylors approach was different insofar as he was one of the first
to account for rational expectations and sticky prices (Taylor & Williams,
2010). He gathered quarterly data from 1982 - 1991 and estimated a monetary policy rule, whereby his idea of setting short-term interest rates (i)
took the following form:
i = r + + 0.5( ) + 0.5Y

(1)

Here r denotes an estimate of the natural real interest rate, denotes

inflation, denotes the implicit inflation target of the Federal Reserve and
Y denotes an estimate of the output gap. In his paper, Taylor assumes both
the implicit inflation target and the natural real interest rate to be at 2%
(Taylor, 1993). Including these figures in the previous equation, his formula
can be rewritten as:

i = 0.01 + 1.5 + 0.5Y

(2)

Taylor supposed that the nominal interest rate should be set at a level
that is at least as big as 1.5 times the level of inflation plus 0.5 times the
level of the corresponding output gap. In his view, shocks to either the
expected level of inflation or shocks that deviate output from its natural
level should be counteracted with a strong interest rate reaction. If inflation
was higher than the target level, a high real interest would be needed to
reduce consumption and investment. This could be achieved by raising the
nominal interest rate more than in proportion with the level of inflation. The
resulting decrease in aggregate demand then leads to a decline in output and
employment. Unemployment increases and firms lower their wages which in
turn decreases money demand and inflation. However, this process might
take up to two years to reach a maximum effect of lower inflation (Gottfries,
2013). The most interesting aspect of his work is whether he was actually
right with his assumptions and how well his rule describes real monetary
policy decisions.

Estimating the Taylor Rule

5.1

Empirical analysis for the United States

This part of the paper estimates the Taylor Rule for the United States
again, using a broad sample of quarterly data from 1954 (quarter 3) until
2014 (quarter 3). The purpose is to examine whether the interest rate responded in line with Taylors suggestions to changes in the inflation gap and
the output gap.
All corresponding data presented in the following were extracted from
the Federal Reserves database. The variables that could not be obtained
directly, were generated with the help of statistical methods and macroeconomic theory. So, the real interest rate for example was calculated employing
the Fisher equation (r i). Moreover, the natural rate of interest (
r) and
10

the natural level of output (Yn ) were estimated using the Hodrick-Prescott
Filter to obtain a smooth long-run trend (with = 1600 due to a quarterly
frequency of the data). Finally, the output gap could be determined from
the estimated natural level of output1 .
Substituting (1 , 2 ) for the coefficients in front of the inflation gap and
the output gap, equation (1) can be rewritten as follows:

i = r + + 1 ( ) + 2 Y

(3)

i = 1 + (1 + 1 ) + r + 2 Y

(4)

Equation (4) allows for an estimation of the implicit inflation target

and the approximated influence of the output gap and the inflation gap
on the nominal interest rate. The natural rate of interest is due to its
composition characteristics assumed to have a weight of 1, which is in line
with John B. Taylors assumptions in the paper, Discretion versus policy
rules in practise. However, taking the full sample (1954Q3 - 2014Q3) into
consideration, leads to inconclusive results.2 Further, the equation should
be reshuffled in a way that fulfills the econometric linearity condition to
perform a break-point analysis. Substituting ( = 1 ) leads to the
following result:

i = + (1 + 1 ) + r + 2 Y

(5)

After the Quandt-Andrews unknown break point test was applied to

equation (5), one could observe a clear and significant break point in 1980Q4.
This coincides with Paul Volckers disinflation in the United States that was
described earlier.3 Many economists that actually addressed the Taylor
n
Y = Y YY
100
n
For the full sample regression table please see the table 3 in the appendix.
3
The Quandt-Andrews unknown break point test is reproduced in Table 4 in the
appendix.

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Rule in their work found similar results. According to Boivin (2005), the
pre-Volcker conduct of monetary policy did not satisfy the so-called Taylor
principle (p. 4).
Consequently, decreasing the sample size from 1954Q3 to 1980Q4 as a
starting date should lead to more robust results. The estimation results of
equation (4) with a sample from 1980Q4 until 2014Q3 are shown below.
Table 2: Taylor Rule estimation: i = 1 + (1 + 1 ) + r + 2 Y

Note: c(1)=1 , c(2)=2 , c(3)=

Substituting the estimated results from the table above into equation (4)
gives the Taylor Rule for the United States from period 1980Q4 to 2014Q3:

i = 0.216 + (1 + 0.216) + r + 0.386Y

(6)

i = + 0.216( ) + r + 0.386Y

(7)

The regression output also shows the implicit inflation target that was
followed by the Federal Reserve ( = 2.324), which is not entirely different from the 2% that Taylor assumed when he developed his rule in 1993.
12

Moreover, conclusions about the effects of the inflation gap and the output
gap can be drawn. Contrary to Taylors original analysis presented above,
the new estimation reveals that fluctuations above the inflation target of 1%
should result in an increase of the nominal interest rate by 0.216 percentage
points, rather than 0.5 percentage points. Furthermore, a 1% increase in
the output gap should lead to an increase in the nominal interest rate of
0.386 percentage points, instead of 0.5 percentage points.

5.2

Exclusion of misspecification and spurious regression

In this section, tests about possible regression misspecifications are analysed

to show that the conclusions above about the estimated parameters are
not biased, since the independent variables are only significant if certain
population properties are met.
5.2.1

Normality test

Although the dataset from 1980Q4 - 2014Q3 contains a significant outlier

and therefore looks slightly skewed to the right, the Jarque-Bera test confirms that the regression residuals are normally distributed with an average
mean of zero.4
5.2.2

Homoscedasticity

To test for the presence of heteroscedasticity the White test was used. The
results show that the null hypothesis of a constant variance cannot be rejected at the 5% significance level in favour of homoscedasticity (Diebold,
2007).
5.2.3

Spurious regression

The results of the regression analysis presented in Table 2 arouse concerns

that the estimated regression might be spurious, due to a high R2 of 0.955.
Moreover, the Augmented Dickey Fuller test shows that three out of four
4

For the Jarque-Bera test please see the appendix, Figure 4

13

analysed variables are stationary in their first differences (the nominal interest rate, the natural rate of interest and the inflation rate). Hence, they are
non-stationary and furthermore, they are cointegrated, because the residuals of model i = 1 + (1 + 1 ) + r + 2 Y are trend stationary. However,
since the output gap is trend stationary, this might result in a spurious regression. Therefore, the Augmented Dickey Fuller test had to be conducted
on the residuals of the simple linear regression between the nominal interest
rate and the inflation rate. The results show that the residuals of the OLS
(i = + t ) which have no unit root are trend stationary. Consequently, it
is likely that the equation (4) (i = 1 + (1 + 1 ) + r + 2 Y ) shows the
coefficients of a long-run equilibrium.5

Conclusion

Contrasting the estimation results (Table 2) with the original Taylor Rule,
one can conclude that Taylors assumptions and argumentations were fairly
reasonable. On average a 1% increase in inflation was followed by an increase
in the nominal interest rate of 1.216 percentage points, which is markedly in
favour of Taylors theory that a deviation from the inflation target should
be responded by a strong interest rate (more than in proportion). However,
there is evidence that this effect is not as large as 1.5. The null hypothesis
that assumes 1 to be equal to 0.5 can be clearly rejected at the 1% significance level [ 0.2160.5
= 6.7]. Similar results hold for the coefficient on the
0.042
output gap. Here, the null hypothesis that 2 was 0.5, can be rejected at
the 5% significance level [ 0.3860.5
= 2.1]. Overall, the estimated Taylor
0.054
Rule in this paper describes monetary policy in the United States from 1980
- 2014 extremely well. The fit of the regression is very high and proven to
be unbiased. In addition, the implicit inflation target ( ) seems not to be
different from 2% [ 2.3242
0.342 = 0.95], which is in line with Taylors assumption
and the recent explicit inflation target of the US. All in all, the Taylor Rule
is widely accepted and yet other countries have estimated it as a general
rule of thumb. Taylor himself remarked in an interview with A. Steelman
5

For the elaborated analysis, please see the appendix.

14

from the Region Focus: The way I think about it is that the Feds actions
have been largely consistent with the rule without using it explicitly (Taylor,
2012). Hence, the Taylor Rule proves to be an adequate guide for monetary
policy.

15

References
[1] Board of Governors of the Federal Reserve System. (2014, January
28). Statement on Longer-Run Goals and Monetary Policy Strategy,
Retrieved December 1, 2014, from http://www.federalreserve.gov/
monetarypolicy/files/FOMC_LongerRunGoals.pdf
[2] Boivin, J. (2005). Has U.S. monetary policy changed? Evidence from
drifting coefficients and real-time data, Journal of Money, Credit and
Banking, vol. 38 (5), pp. 1149-1174
[3] Diebold F.X. (2007). Elements of forecasting, 4th edition, Thomson.
[4] Federal Reserve. (2014, November 3). Why are interest rates being kept at
a low level? Retrieved from http://www.federalreserve.gov/faqs/
money_12849.htm.
[5] Federal Reserve Economic Data. (2014). Effective Federal Funds Rate
[Data file]. Retrieved from http://research.stlouisfed.org/fred2/
series/FEDFUNDS
[6] Federal Reserve Economic Data. (2014). Gross Domestic Product: Implicit Price Deflator [Data file]. Retrieved from http://research.
stlouisfed.org/fred2/series/GDPDEF
[7] Federal Reserve Economic Data. (2014). Real Gross Domestic Product
[Data File]. Retrieved from http://research.stlouisfed.org/fred2/
series/GDPC1
[8] Goodfriend M. & King R.G. (2005), The incredible Volcker disinflation,
Journal of Monetary Economics, vol. 52 (5), pp. 981-1015.
[9] Gottfries N. (2013). Macroeconomics, Palgrave Macmillan.
[10] OECD (2014), OECD Economic Outlook November 2014, vol. 96, Paris.
[11] Taylor, J. B. (1993) .Discretion versus Policy Rules in Practice.
Carnegie-Rochester Conference Series on Public Policy 39: 195-214.
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[12] Taylor, J. B. (2012, February 24). Interview John B. Taylor (A. Steelman, Interviewer). Retrieved from http://www.richmondfed.org/
publications/research/region_focus/2012/q1/pdf/interview.
pdf
[13] Taylor, J. B., & Williams, J. C. (2010). Simple and Robust Rules for
Monetary Policy, Retrieved from National Bureau of Economic Research
website: http://www.nber.org/papers/w15908.pdf
[14] Thornton, D. L. (2012). How did we get to Inflation Targeting and
where do we need to go to now?

A perspective from the U.S. ex-

perience (94(1)), Retrieved from Federal Reserve Bank of St. Louis

website:

http://research.stlouisfed.org/publications/review/

12/01/65-82Thornton.pdf

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[?, ?, ?, ?, ?, ?, ?]

List of Figures
1

Development of the output gap over time . . . . . . . . . . .

Development of the federal funds rate over time. . . . . . . .

Development of the GDP deflator over time . . . . . . . . . .

Normality Test . . . . . . . . . . . . . . . . . . . . . . . . . .

20

List of Tables
1

12

Estimation results : regress . . . . . . . . . . . . . . . . . . .

Taylor Rule estimation: i = 1 + (1 + 1 ) + r + 2 Y . .
Full sample regression: i = 1 + (1 + 1 ) + r + 2 Y . . .

Unknown break point test . . . . . . . . . . . . . . . . . . . .

19

White heteroscedasticity test . . . . . . . . . . . . . . . . . .

20

ADF test on the nominal interest rate . . . . . . . . . . . . .

21

ADF test on the inflation . . . . . . . . . . . . . . . . . . . .

21

ADF test on the natural rate of interest . . . . . . . . . . . .

21

9
10

ADF test on the output gap . . . . . . . . . . . . . . . . . . . 22

ADF test of the residuals of the i = 1 + (1 + 1 ) + r + 2 Y 22

11

Simple OLS estimation i = + t . . . . . . . . . . . . . . . .

23

12

ADF test on the residuals of i = + t . . . . . . . . . . . . .

23

18

3
19

7
7.1

Appendix
Empirical Estimation of the Taylor Rule
Table 3: Full sample regression: i = 1 + (1 + 1 ) + r + 2 Y

Note: c(1)=1 , c(2)=2 , c(3)=

Table 4: Unknown break point test

A break point in 1980Q4 is found.

19

7.1.1

Misspecification tests
Figure 4: Normality Test

We fail to reject the Jarque-Bera H0 : at a 5% significance level, with a

p-value of 0.49, so the residuals seem to be normally distributed.
Table 5: White heteroscedasticity test

We fail to reject the White H0 : at a 5% significance level, with a p-value of

0.092, so the variance is likely to be constant.
7.1.2

Spurious Regression Examination

In this section it is examined if concerns about spurious regression are justified. First the Augmented Dickey Fuller tests are conducted and it is
found that all series, except the output gap (Y ), are trend non-stationary.
Moreover, the two step Engel-Granger test shows that the combination of

20

variables leads to the lower order of integration in the residuals, hence the
series are cointegrated.
Table 6: ADF test on the nominal interest rate

Table 7: ADF test on the inflation

Table 8: ADF test on the natural rate of interest

21

Table 9: ADF test on the output gap

To check if our series are cointegrated, an ADF test on the residual of

the i = 1 + (1 + 1 ) + r + 2 Y is preformed, showing that there is no
unit root:
Table 10: ADF test of the residuals of the i = 1 + (1 + 1 ) + r + 2 Y

Afterwards, the order of integration of the residuals in i = + t is analysed. The result of the unit root test leads to the conclusion that concerns
can be rejected that i = 1 +(1+1 ) + r +2 Y is a spurious regression.

22

Table 11: Simple OLS estimation i = + t

Table 12: ADF test on the residuals of i = + t

23