Taylor-type rules versus optimal policy in a Markov-switching economy

• Author(s): Alexandre, Fernando ; Gabriel, Vasco J. ; Bação, Pedro
• Date: 2008
• Persistent ID: http://hdl.handle.net/1822/7881
• Origin: RepositóriUM - Universidade do Minho
• Subject(s): Asset prices; Monetary policy; Markov switching
• Document Type: Research paper
• Language: English

Description

We analyse the effect of uncertainty concerning the state and the nature of asset price movements on the optimal monetary policy response. Uncertainty is modelled by adding Markov-switching shocks to a DSGE model with capital accumulation. In our analysis we consider both Taylor-type rules and optimal policy. Taylor rules have been shown to provide a good description of US monetary policy. Deviations from its implied interest rates have been associated with risks of financial disruptions. Whereas interest rates in Taylor-type rules respond to a small subset of information, optimal policy considers all state variables and shocks. Our results suggest that, when a bubble bursts, the Taylor rule fails to achieve a soft landing, contrary to the optimal policy.