Monetary Policy Rules in Practice: Some International Evidence By Richard Clarida, Jordi Gali & Mark Gertler Presented by Alyaa Ezzat Sept. 1997

Overview This paper estimates the monetary policy reaction function for two sets of countries: G3 & E3 Since 1979 each of G3 has followed an implicit form of inflation targeting which achieved broad success of monetary policy in those countries. These central banks were forward looking responding to anticipated inflation as opposed to lagged inflation. For the E3, even prior to the “hard ERM” E3 central banks were heavily influenced by German’s monetary policy Using Bundesbank’s policy rule as a benchmark, the time of EMS collapse, (i)’s were much higher than the domestic macroeconomic conditions warranted. Conclusion: some form of inflation targeting may be superior to fixing exchange rates as means to gain nominal anchor for monetary policy.

Two issues that motivate investigation First 1) After nearly a decade of high inflation, a number of important CB in 1979 wanted to reign inflation. 2) Inflation seemed a serious problem where major economies of the world enjoy relative stable prices. 3) Monetary policy was viewed as out of control in 1970s How policy was conducted in the post- 79 era that had a great influence over the global monetary policy & policy management! That is why they wanted to study G3

Two issues that motivate investigation Second: 1) The collapse of the EMS in late ) Inability to major European CBs to sustain the existing exchange rate system Studying E3 to understand how constraints of EMS influenced the policies of these countries. - They use the policy rule estimated for G3 as guideline to evaluate future policy making in Europe.

Methodology 1) Estimating reaction function: *Baseline specification has a central bank adjust the nominal short term interest rate in response to the gaps between expected inflation & output with their targets respectively. “not subject to any external constraint” A forward looking version of the simple backward looking reaction function popularized by Taylor (1993)

Cont. Methodology *Alternative baseline specification that permits the CB respond to variables other than the inflation & output as for the case of the E3, these countries faced an external constraints on monetary policy. The alternative also permits a test of Forward vs backward looking specification of the reaction functions

Reaction function It’s what the CB uses to respond to shocks to the economy and steer it toward an explicit or implicit inflation target. Tasks of reaction function: 1) nominal anchor “inflation target” for the medium run 2) Provide guidance to how the CB’s policy instruments, i should be adjusted in response to different shocks.

Analysis G3 : 1) baseline specification of the reaction function worked well in characterizing monetary policy post-79 In response to the rise of expected inflation relative to target, each central bank raises the nominal rate sufficiently to push real rate. r nominal = r real + π 2) The estimated MR imply a clear focus on controlling inflation.

Background scenario Policy reaction works as follows: CB has a target for the nominal short term interest rate based on the state of the economy The target depends on both expected inflation and output _ r Long run equilibrium real interest rate r* short run nominal interest rate based on the economy Ω information available to CB at the times it sets r

Background scenario When CB chooses target interest rate; information about current output & price level rr* in the real interest rate rr Long run equilibrium real interest rate B is the CB preference B could be > or < or = 1

Central Banks’ Preferences

CB is inflation averse B>1

Monetary Rule

Background scenario 6 key variables in CB policy making

Forward looking The alternative baseline: the alternative variables are: 1) real exchange rates 2) foreign interest rates 3) the money supply with also the lagged inflation