Candidate: Rajeev Sooreea

Degree of: Doctor of Philosophy

Department: Economics

Title: Taylor-Based Monetary Policy Rules: Are They Forward-Looking, Data Congruent, and Asset Price Responsive?

Committee:
Dr. Matthew Higgins , Chair
Dr. Eskander Alvi
Dr. Ajay Samant

Date: Monday, November 3, 2003 10:00 am - 12:00 pm
5302 Friedmann

Abstract: This dissertation presents three essays to analyze a class of Taylor-based monetary policy rules that forms the basis of contemporary monetary policy decisions. The first essay addresses the issue of whether Taylor-based monetary policy rules are forward-looking. The analysis is done by invoking the Lucas critique and superexogeneity tests. The paper proposes the methodology that, if the parameters of the Taylor rule change when the mechanism generating inflation changes, that is the Lucas critique applies, then inflation is not superexogenous for the parameters of the Taylor rule. In this case where superexogeneity fails, the rule is forward-looking. However, the empirical results indicate that the conditional Taylor rule model is not affected by the first and second moments of the residuals from the marginal Phillips curve model. This invariance result implies that the Lucas critique does not apply and policy rules are not forward-looking. Hence, monetary policymakers can change the process that determines inflation without affecting the process that determines the Fed Funds rate.
The second essay examines which types of Taylor-based policy rules are data congruent. The literature has produced numerous amounts of policy rules which are essentially rivals to each other. Hence, this essay focuses on a set of non-nested interest rate rules to identify which model most appropriately characterizes the short interest rate data generating process. Five inflation measures and four output gap measures are studied and 116 non-nested P tests are conducted to show that the measures of inflation and output gap that are most consistent with the Fed Funds rate behavior are the Philadelphia Fed expected inflation and the Congressional Budget Office output gap. The resulting model encompasses competing alternatives and is data congruent.
The third essay augments the model from the second essay to investigate whether the Fed reacts to the stock market while designing monetary policy. To quantify the component of asset price movements, it employs a non-linear model of intrinsic bubbles to isolate market fundamentals from stock prices, and an Exponential Generalized Autoregressive Conditional Heteroskedastic model to gauge volatility clustering and leverage effects inherent in equity returns. These constructed measures of asset bubbles, fundamental values and volatility are then used as additional indicators in an augmented Taylor rule. Results of estimated reaction functions show that the Fed lowers interest rates to inject liquidity in the market in response to an increase in volatility and uncertainty. Moreover, there is evidence that the Fed responds pro-cyclically to market fundamentals and accommodates higher productivity gains. However, there is no strong evidence from a policy perspective that the Fed responds to asset price bubbles.

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