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TAYLOR RULE IN EAST ASIAN COUNTRIES Shahdad Naghshpour The University of Southern Mississippi.

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Presentation on theme: "TAYLOR RULE IN EAST ASIAN COUNTRIES Shahdad Naghshpour The University of Southern Mississippi."— Presentation transcript:

1 TAYLOR RULE IN EAST ASIAN COUNTRIES Shahdad Naghshpour The University of Southern Mississippi

2 ABSTRACT One of the most important policy changes has been the adoption of inflation targeting. This paper explores inflation targeting in Asian nations. To this end we calculate the presumed inflation target in Indonesia, Japan, South Korea, Thailand, and Taiwan by utilizing the Taylor rule.

3 Inflation targeting as an overall monetary policy comprises five factors (Mishkin & Miguel 2001). First, a commitment to announce publicly what the medium-term target rates is for inflation by the central banking authorities. Second, an institutional commitment made by the central authorities to price stability as the overarching goal of monetary policy. Third, extensive analysis and information gathering is essential to ensure that a variety of measures are available for decision makers to formulate policy. Fourth, transparency in the political and financial systems, particularly in the central bank, is essential for inflation targeting to be successful. Fifth, the central bank and its directing body must be held accountable for the banks actions.

4 Taylor Rule The Taylor rule is a monetary policy rule. This type of rule models the processes whereby a central bank makes adjustments to interest rates based upon existing economic reality. The rules are responsive, calling for changes in the money supply, the monetary base, or the short-term interest rate in response to changes of the price level or real income (Taylor 1993).

5 The Taylor Rule John Taylor presents a monetary policy rule that he characterizes as one, that captures the spirit of the recent research and which is quite straightforward (Taylor 1993). Thus we find the following formulation and coefficients. r=p+.5y +.5(p-2) + 2 where r= the federal funds rate, p= the rate of inflation over the previous four quarters y= the percent deviation of real GDP from a target. That is, y= 100(Y-Y*)/Y* where Y= real GDP, and Y*= is the trend real GDP

6 THE MODEL it = α + ρit-1 + β πt +γ Yt +ε Where it is the nominal interest rate πt is the inflation rate in time t Yt is the output gap

7 Results The results for each country are presented separately. South Korea declared inflation targeting as its monetary policy in 1998. In the year 2000 Thailand did the same. Although Indonesia announced inflation targeting in 2005, there is not enough data to study the impact of the policy decision. Japan and Taiwan also pursue inflation targeting, but so far we have not been able to determine the actual date the policy became effective. The t-values are in parentheses under corresponding coefficients.

8 INDONESIA The estimated equation for Indonesia is: it = -.004 inflation – 1.95 output gap +.96 it-1 (.85) (.56) (47.94) The adjustment coefficient is very close to one indicating rapid adjustment for interest rates. This value is close to estimates obtained by others however, it is on the high end (Clarida, Gali & Gertler 1997). The coefficients for inflation and output gap are not significant so one cannot put too much stock in their signs. For all practical purpose they are zero, indicating that inflation targeting or output targeting are not the primary policy objectives of the Central Bank of Indonesia. On the other hand, the bank resorts to shock therapy; it adjusts interest rates very rapidly. Almost in one period, which is a month for this study, the interest rate reaches to its targeted rate. The adjusted R-squared is 94%

9 JAPAN The estimated equation for Japan is: it = -.005 inflation +.29 output gap +.97 it-1 (0.67) (0.97) (150.4) The adjusted R-Squared for Japan is 99%, the highest among the countries under review. It also has the largest coefficient for interest rate adjustment mechanism, indicating the fastest correction among these countries. However, since the coefficients for inflation or output gap are not significant the policy objective of the central bank of Japan cannot be determined. The overnight rate for Japan has been close to zero for several years, which might have contributed to lack of significance of the variables.

10 SOUTH KOREA The estimated equation for South Korea is: it = -.01 inflation + 4.73 output gap +.96 it-1 (1.02) (2.42) (31.87) The adjusted R-Squared is 95%. For South Korea too, adjustments in interest rates are rapid. Although the inflation coefficient is not significant the coefficient for output gap is highly significant indicating output targeting in South Korea for the study period.

11 TAIWAN The estimated equation for Taiwan is: it = -.009 inflation + 1.05 output gap +.92 it-1 (1.75) (0.7) (33.22) The adjusted R-Squared is 86%. Although the adjustment factor is lower than that of Indonesia it is fairly high. Furthermore, the coefficient for inflation is significant at the 8%, therefore there is some evidence of inflation targeting.

12 THAILAND The estimated equation for Thailand is: it = -.007 inflation + 1.94 output gap +.94 it-1 (0.677) (0.85) (32.06) The adjusted R-Squared is 84%. However, the only significant variable is the lagged interest rate, which also has a high value indicating fairly rapid implementation of changes in interest rates. Since the other coefficients are not significant no inference can be made about the policy target of the central bank.

13 CONCLUSIONS The results for the reaction functions of these far-east Asian countries are similar. They all have very high adjusted R-Squares, in part due to inclusion of the lagged interest rate. All have fairly high adjustment coefficients indicating that the changes in interest rate are implemented very quickly. Since the periodicity of the data is monthly the central banks of these nations adjust to their desired rate of interest within a month at the rate of Indonesia 96%, Japan 97%, South Korea 96%, Taiwan 92%, and Thailand 94%. These are much higher than the adjustment rates reported for new entrants to the European Union and close to the estimate for Japan (Maria- Dolores 2005; Clarida, Gali & Gertler 1997). In several cases it is not possible to determine if the respective central banks of these countries are pursing an inflation targeting or an output targeting policy. The clear exceptions are Taiwan (inflation targeting) and South Korea (output targeting).

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