MACROECONOMIC POLICY POLICY REACTION FUNCTIONS: INFLATION FORECAST TARGETING AND TAYLOR RULES

Transcription

1 EC307 EPUK - Macroeconomic Policy ECONOMIC POLICY IN THE UK MACROECONOMIC POLICY POLICY REACTION FUNCTIONS: INFLATION FORECAST TARGETING AND TAYLOR RULES Summary We compare inflaion forecas argeing wih a Taylor rule. Reading Bernanke, Ben (2004), The logic of moneary policy hp:// Bofinger, Peer (200), Moneary Policy, sec 8.5. Carare, Alina and Tchaidze, Rober (2005), The use and abuse of Taylor rules: how precisely can we esimae hem?, IMF Working Paper WP/05/48. [advanced in pars; sugges skip/skim secion III] hp:// Carlsrom, Charles T. and Fuers, Timohy S. (2003), The Taylor rule: a guidepos for moneary policy?, Federal Reserve Bank of Cleveland Economic Commenary (July). hp:// McCallum, Benne T and Nelson, Edward (2005), Targeing versus insrumen rules for moneary policy, Federal Bank of S Louis Review (Sep/Oc), hp://research.slouisfed.org/publicaions/review/05/09/mccallum.pdf Nelson, Edward (2000), UK moneary policy : a guide using Taylor rules, Bank of England Working Paper 20. hp:// [read selecively] Svensson, Lars (2003), Wha is wrong wih Taylor rules? Using judgmen in moneary policy hrough argeing rules, Journal of Economic Lieraure, 4, hp:// [long paper, read selecively] Svensson, Lars (2005), Targeing versus insrumen rules for moneary policy: wha is wrong wih McCallum and Nelson?, Federal Bank of S Louis Review (Sep/Oc), hp://

2 2 ECONOMIC POLICY IN THE UK MACROECONOMIC POLICY POLICY REACTION FUNCTIONS: INFLATION FORECAST TARGETING AND TAYLOR RULES Ineres rae rules derived from inflaion forecas argeing When he CB arges inflaion, and ses policy so ha forecas inflaion is on arge, we saw ha we could derive rules ha ell he CB wha level of ineres raes i should se. For he case where some weigh is pu on oupu, in he model previously se ou, based on Svensson (997), he reacion funcion was: + β i = π ( π π*) y. α β β 2 2 This implici ineres rae rule has srong similariies wih he Taylor rule, a famous policy guideline which has a compleely separae hisory from inflaion forecas argeing. I is useful o compare inflaion forecas argeing and he Taylor rule as wo differen policy descripions/prescripions. There is some (someimes lively) debae in he lieraure abou he connecions beween he wo, and which is beer. Wha is a Taylor rule? Taylor s rule is a formula developed by Sanford economis John Taylor. I was designed o provide recommendaions for how a cenral bank should se shor-erm ineres raes o achieve boh is shor-run goal for sabilising he economy and is long-run goal for inflaion. Taylor (993) esimaed policy reacion funcions and found ha moneary policy can ofen be well approximaed empirically by a simple insrumen rule for ineres rae seing. The following is one varian of he Taylor rule: i = r* + π* + β(π π*) + γ(y y N ) () where β, γ > 0; r* is he average (long-run) real ineres rae. The rule saes ha he repo rae i should be above is long-run level (r* + π*) when: acual inflaion π is above he arge π* economic aciviy y is above is "full employmen" level y N (i.e. he oupu gap is posiive) Is he Taylor rule a good descripion of how moneary policy operaes? Taylor, John B "Discreion Versus Policy Rules in Pracice", Carnegie-Rocheser Conference Series on Public Policy, 39, pp

3 3 Esimaed Taylor rules pu numbers on he parameers β and γ. Taylor (993) found ha β=.5 and γ=0.5: i = r* + π* +.5(π π*) + 0.5(y y N ) (2) Nelson (2000) 2 found coefficiens of.3 and 0.5 during he period (pos-inflaion argeing and pre-independence) similar o hose found by Taylor. For previous years, hough, he coefficiens were very differen, wih coefficiens on inflaion much lower han and varying oupu gap responses. Noe ha unless he (long-run) coefficien on inflaion is above, he inflaion arge will no be achieved on average (his has been called he Taylor principle ). In his case, moneary policy would have failed o provide a nominal anchor: effecively, inflaion would no be ied down o a fixed value. Nominal ineres raes naurally respond one-for-one wih increases in inflaion (recall he Fisher relaion i =r +π ), so a coefficien of exacly uniy would mean he cenral bank was no aemping o counerac inflaion movemens. I is only when he coefficien on inflaion exceeds uniy ha he cenral bank is leaning agains he wind. In he lieraure you may see he equaion wrien as Taylor originally esimaed i, namely: i = π (π - 2) + 0.5(y - y N ) ( ) This is simply a rearranged version of (), wih Taylor s numerical assumpions ha he Fed effecively followed an inflaion arge of 2% beween 987 and 993, and ha he long run real ineres rae was also 2%. Taylor also used one-period lags o allow for realisic delays in policy response, parly due o he fac ha policy decisions are ypically responses o daa, and daa producion akes ime. To clarify ha () and ( ) have idenical forms, replace Taylor s assumed values for he real ineres rae and he inflaion arge wih heir algebraic represenaions: i = π - + r* + 0.5(π - π*) + 0.5(y - y N ) ( ) As in (), he sum of he coefficiens on π - (or π ) is.5, and he sum of he coefficiens on π* is 0.5. Taking π - over o he LHS of ( ) gives an equaion for he real Federal funds rae (he nominal rae minus inflaion). Taylor s rule says ha he real Fed funds rae should be raised 0.5 percenage poins for every percenage poin inflaion rises above arge, and should also be raised 0.5 percenage poins for every percenage poin acual oupu rises above poenial. Research for oher counries, including he UK, has found a significan lagged dependen variable: i - appears on he righ hand side, as an addiional regressor, wih a posiive coefficien significanly less han uniy. A reasonable inerpreaion of his is ha cenral banks (including he BoE), conduc ineres rae smoohing: hey deliberaely make gradual ineres rae changes, reducing poenially damaging ineres rae volailiy. In he long-run (if here were no changes in inflaion, he arge, or he oupu gap), given ha ha lagged dependen variable has a coefficien<, his smoohing would peer ou, so he long-run equaion would look exacly like (). The Taylor rule is acknowledged by all o be a simple approximaion o acual policy behaviour. I represens a complex process wih a small number of parameers. The Taylor rule is ofen hough of as a good approximaion. Empirical work for he US suggess ha he Taylor rule does a fairly accurae job of describing how moneary policy acually has been conduced during he pas decade under Fed Chairman Greenspan. 2 Nelson, Edward "UK moneary policy : a guide using Taylor rules", Bank of England Working Paper 20.

4 4 Jane Yellen, hen Fed Reserve Governor, said in he January 995 FOMC meeing I seems o me ha a reacion funcion in which he real funds rae changes by roughly equal amouns in response o deviaions of inflaion from a arge of 2 percen and o deviaions of acual from poenial oupu describes reasonably well wha his commiee has done since 986. If we waned a rule I hink he Greenspan Fed has done very well following such a rule, and I hink ha is wha sensible cenral banks do. The graph below compares he value of he Fed funds rae prediced by he above Taylor rule ( ) and compares i agains he acual Fed funds arge (i.e. he repo rae). The Taylor rule racks broad movemens in he repo rae quie well, alhough here are some large and persisen mispredicions. Noe ha he fi up o 993 he period over which Taylor esimaed his equaion and obained his coefficiens is very good. Bu one of he ess of a good model is is abiliy o predic ou-of-sample. Alhough many sudies (including Taylor s original work) have found ha he Taylor rule does fi well in economeric erms, his fi explains only 80% of ineres rae movemens in his example. In oher words, 20% is unexplained by he oupu gap and inflaion. Source: Carlsrom and Fuers (2003) Conclusion: surprisingly good model, given small number of variables. Seems a good parsimonious model of policy. Should moneary policy operae according o a Taylor rule? Clearly, if viewed prescripively, he rule provides guidance (via he size of he parameers β, γ) o policymakers on how o balance he poenially compeing consideraions of inflaion and oupu deviaions.

5 5 Defenders of he Taylor rule (including he man himself) say he never mean i as a mechanical rule, bu only as a guideline. Policymakers are allowed o deviae from i, bu would need o jusify such deviaions. Policy could respond o oher variables oo, alhough inflaion and he oupu gap are he only ones policy should consisenly respond o, according o he Taylor rule. Svensson is criical of his, arguing ha he guidance provided by he Taylor rule is incomplee and oo vague o be operaional : some deviaions are allowed, bu here are no rules for when deviaions from he insrumen rule are appropriae (2003, p.3). There are several pracical problems wih he implemenaion of a Taylor rule (Bofinger, 200, sec 8.5.3). The Taylor rule requires ha (in he seady sae when inflaion is a arge and oupu is a he naural level) he repo rae be se equal o he long-run (or seady sae) real ineres rae plus inflaion (see ( )). The real ineres rae is no observable and measuring/esimaing i is no easy, so deciding he normal (or neural ) level of nominal raes is difficul oo. Bofinger poins ou ha deciding wha inflaion measure o use, and measuring he oupu gap, also presen pracical obsacles o he Taylor rule. I is worh noing ha raher han using acual values of inflaion (and oupu) o adjus policy according o he Taylor rule, some have suggesed using forecass of hese variables. Bu he heoreical argumens for doing so are no srong, and no significan empirical advanage has been found (see Bofinger, 200, sec 8.5.4). Inflaion forecas argeing versus insrumen rules How does he Taylor rule (an insrumen rule) differ from he policy reacion funcion ha can be derived from he Svensson model (which is based on inflaion forecas argeing)? Svensson hinks hey are very differen. He hinks ha policy is no well described by he Taylor rule, and nor should policymakers follow a Taylor rule. McCallum and Nelson vigorously defend insrumen rules and aack he noion of argeing rules. We begin by defining erms, hen we make a couple of poins, and hen we urn o he academic debae. Some definiions: McCallum and Nelson (2005) = McCN Svensson (2003) = S2003 Svensson (2005) = S2005 Insrumen rule = formula for seing a conrollable insrumen variable in response o currenly observable variables (McCN and S2005) Specific argeing rule = a condiion o be fulfilled by he cenral bank s arge variables (or forecass hereof) (S2005 p.64) = a firs-order opimaliy condiion derived from a specific objecive funcion for he cenral bank and a specific model of he economy (McCN) e.g. Choose i such ha E π + 2 = π * as in he Svensson model discussed previously * λ e.g. Choose i such ha π + π + ( y+ y ) = 0, as in he model se ou below, α y from S2005. Ignore discussion of he erm general argeing rule i s no a very useful concep, and has no been used in a consisen way in he lieraure.

6 6 A couple of poins: The Taylor rule is an explici rule for ineres raes, whereas he reacion funcion from he Svensson model is implici. In he Svensson model, wha really drives policy is he difference beween he inflaion forecas and he arge (and he oupu gap forecas if he CB cares abou oupu). The underlying reason ha inflaion deviaions and he oupu gap appear in he implici ineres rae rule under inflaion forecas argeing is ha hey are involved in he forecasing model for inflaion. In conras, under he Taylor rule, hey maer in hemselves. Svensson versus McCallum and Nelson S2003 claims ha argeing rules are superior o insrumen rules for various reasons (see below). Mos poins are rebued by McCN, and hen defended by S2005. In relaion o poins ()-(4), McCN claim ha all four of he objecions o insrumen rules emphasized by Svensson are equally applicable or equally inapplicable o argeing rules (p.60).. S2003: Simple insrumen rules don conain enough relevan variables [a] firs obvious problem for a Taylor-syle rule is ha, if here are oher imporan sae variables han inflaion and he oupu gap, i will no be opimal For a smaller and more open economy [han he US], he real exchange rae, he erms of rade, foreign oupu, and he foreign ineres rae seem o be he minimal essenial sae variables ha have o be added [for he rule o be opimal] (S2003 p. 442). - McCN couner his by saying ha he oher variables may no be imporan, and cie wo well-known models (Clarida, Gali and Gerler (200) and McCallum-Nelson (999)) which are open-economy models bu don (need o) conain erms oher han he ineres rae, oupu and he inflaion rae (McCN p.600). 2. S2003: Simple rules don allow any role for judgemen A second problem, is ha a commimen o an insrumen rule does no leave any room for judgmenal adjusmens and exra-model informaion (S2003 p. 442). S2003 argues ha if he CB followed a Taylor rule, he coefficiens would be known/decided upon, and all he CB would have o do o se ineres raes is measure he oupu gap and inflaion each period. Svensson conrass his wih he large number and complexiy of facors considered in acual moneary policy making, e.g. he BoE Inflaion Repor, ha deermine wha happens o UK ineres raes. S2003 argues ha argeing rules have he imporan advanage ha hey allow he use of judgemen and exra-model informaion (Svensson (2003), p.55). [Consider he role played by he forecasing process in an inflaion argeing regime. How imporan is his in inherenly allowing judgemen, due o is complexiy (or imprecision?). Could/should a similar process be involved when an insrumen rule is used?] - Conrary o his, McCN claim ha judgemen has a role under insrumen rules: for example, he insrumen could be se above (or below) he rule-indicaed value when policymaker judgmens indicae ha condiions, no adequaely refleced in he cenral bank s formal quaniaive models, imply differen forecass and consequenly call for addiional policy ighening (or loosening). (p.600) S2005 argues ha McCN s idea of judgemen involves subsanial discreion (over wha condiions o ake ino accoun and how o esimae heir impac). McCallum and Nelson seem o believe ha a commimen is consisen wih discreionary adjusmens, an obvious conradicion (S2005 p.66).

7 7 3. S2003: Simple rules don allow policymakers o reac o new informaion abou he ransmission mechanism or shocks - McCN claim ha i is possible o commi o a procedure raher han a formula (p.60), i.e. o commi o a framework wihin which changing insrumen rules can be applied. 4. S2003: No cenral bank has commied o an insrumen rule Svensson asks why no Cenral Bank promises o follow a Taylor rule, despie he benefis i could apparenly bring: credibiliy would be very high for a CB ha made such a promise and published he relevan Taylor rule coefficiens, as he oupu gap and inflaion ec are easily measurable. [Conras his ransparency and low-cos accounabiliy wih he difficuly of monioring and judging he Bank of England s forecasing process. Bu also consider wheher ransparency could be mainained if he judgemen discussed in poin 2 were allowed.] - McCN couner ha no cenral bank has commied o an explici objecive funcion, which hey claim is a necessary par of commimen o a specific or general argeing rule. They noe ha a a minimum i would be necessary for he cenral bank o sae explicily is weigh on oupu deviaions in he objecive funcion (λ in Svensson s model), and o use a paricular model. [Is one reason no CB follows a Taylor rule explicily ha i would ie heir hands oo much, i.e. i would cos oo much in erms of los discreion? Could he same be said for he publicaion of he parameers of a argeing rule?] 5. S2003: Simple insrumen rules don fi cenral bank behaviour well Even he bes empirical fis leave one hird or more of he variance of changes in he [ineres insrumen] rae unexplained (S2003 p.444). - McCN couner ha (a) explaining wo-hirds of he variance of he firs-difference of he ineres rae is prey good for a firs-differenced variable, and raher cheekily compare his o he 70%+ of he variance of he firs difference of each of inflaion and he oupu gap in Svensson s own work wih Glenn Rudebusch (999). McCN also noe ha (b) when you look a he level of he ineres rae, almos all variaion can be explained by an insrumen rule: Judd and Rudebusch (998 p.4) repor a residual sandard deviaion of 0.27 for he Greenspan period 987Q3-997Q4. Over ha span, he sandard deviaion of he quarerly average funds rae is.93 (annual percenage unis). Thus, he unexplained fracion of variabiliy is (0.27/.93)2 = (p.60). 6. S2003: Cenral banks noed as leading inflaion argeers (Bank of England, RBNZ, Bank of Canada) follow procedures ha can be beer characerised as following a argeing rule han following an insrumen rule. - McCN claim insead ha descripions of heir policy procedures provided by officials and economiss of hese cenral banks read more like insrumen rules han specific argeing rules (p.602). They cie wo of several shor aricles in he Bank of Canada Review published in he summer of 2002, and various Bank of England and RBNZ documens, all of which refer o he use of an insrumen rule or reacion funcion, and some of which conduc empirical experimens using a variey of differen insrumen rules. McCN sugges ha his focus on insrumen rules is supporive of cenral banks being beer described as using Taylor rules. - [This ype of evidence, however, canno be conclusive. If he reacion funcion ha resuls from inflaion forecas argeing behaviour looks very like a Taylor rule, i is difficul o be cerain ha cenral banks exacly wha cenral banks are hinking when hey perform such experimens. Furhermore, here is nohing o sop cenral banks running experimens using echniques hey don employ, nor expressing he way policy is formulaed in he simple, readily-undersood erms of a Taylor rule. However, he

8 8 addiional fac ha here is no aemp o evaluae policy using a numerically specified loss funcion or Euler equaion (p.602) migh seem more imporan. Why, if cenral banks are inflaion forecas argeers, are hey no more open abou he precise rules hey follow?] S2005 couners McCN o some exen by ciing a large and growing number of papers on inflaion forecas argeing. [Again, hough, his is no very convincing here are fashions in publicaions, and a endency for relaively new ideas o ge a lo of aenion iniially.] 7. McCallum and Nelson argued in previous papers ha insrumen rules can be wrien o saisfy any specific arge rule, by increasing he size of he response coefficien on he paricular variable (or prevailing condiion ) ha needs o be adjused o mee he arge. S2003 had claimed ha i was unwise and impracical o have very large response coefficiens. - McCN run some simulaion experimens and conclude ha here is lile difference beween he performance insrumen and argeing rules when policymakers make a misake abou economic condiions. S2005 couners ha if he error is no immediaely realised, insrumen rules can perform very badly. He also poins ou ha whereas argeing rules are by definiion opimal, varying he response coefficien in insrumen rules finiely (raher han infiniely) can on some occasions only ge close o opimaliy. 8. McCN argue ha specific argeing rules are always specific o a paricular model, and hence depend on assumpions abou he (dynamics of he) model s IS and Phillips curves and oher srucural equaions (p.599). McCN criicise specific argeing rules because alhough hey are by definiion opimal for a cerain model, hey may well no be opimal for anoher model. In conras, hey say, insrumen rules can be defined ouside paricular models and esed in a variey of models, and he bes insrumen rule over he range of models can be seleced. McCN give some numerical examples in which he opimal rule in one model gives resuls in anoher model ha are (someimes much) more han wice as bad as he opimum for ha model (p.599). Targeing rules as srucural, robus, and compac S2005 argues ha argeing rules have an advanage over insrumen rules in ha hey are derived from opimal behaviour of economic agens and policymakers (i.e. are srucural ), and correspond o a sandard efficiency condiion (p.620). We illusrae his using he model in S2005. S2005 makes a useful analogy wih consumpion heory. Old consumpion models used o model consumpion as a simple funcion of income and he real ineres rae, and possibly oher variables: C = f ( R, Y,...) (3) which is no a srucural relaionship bu a reduced form whose properies and parameers depend on he whole model of he economy, including he exising shocks and heir sochasic properies, he moneary and fiscal policy pursued, and so forh (S2005 p.67) Modern consumpion heory and empirics insead focuses on he Euler equaion ha consumpion has o fulfil ha is, a firs order condiion ha mus be fulfilled for he consumpion choice o be opimal. S2005 gives he example of an Euler condiion ha holds under cerain assumpions (for an addiively separable uiliy funcion of a represenaive consumer):

9 9 δu C ( C+ E ) = (4) U C ( C ) + R where δ is a discoun facor and U C (C ) is he marginal uiliy of consumpion. All his says is ha he consumer should choose consumpion in he curren and fuure period so ha he expeced marginal rae of subsiuion of curren consumpion for fuure consumpion (i.e. he LHS of he equaion, which measures he relaive uiliy of discouned fuure and curren consumpion) equals he marginal rae of ransformaion (i.e. he RHS of he equaion, which capures he real ineres rae a which he consumer could borrow or lend, hence he rae a which hey are able o ransform curren consumpion ino fuure consumpion). The Euler equaion is more srucural, independen of he res of he model (S2005 p.67). S2005 (raher rudely) compares he old consumpion funcion o an insrumen rule, and he Euler equaion o a argeing rule. Why is a argeing rule like he Euler equaion? Targeing rules such as hose suggesed by Svensson do ry o minimise loss he opimal argeing rule is simply, and fundamenally, a resaemen of he sandard efficiency condiion of equaliy beween he marginal raes of subsiuion and ransformaion beween he arge variables (namely inflaion and he oupu gap) (S2005, p.69). The MRS beween inflaion and he oupu gap follows from he form of he loss funcion, including he relaive weigh on oupu λ. The MRT beween inflaion and he oupu gap is deermined by of he AS relaion (equaion () in he Svensson model previously discussed), including he slope of he shor-run Phillips curve (α in ha model). (Noe ha he AD relaionship (equaion (2)) does no deermine he MRT, so he argeing rule is robus o changes in he AD relaionship.) The parallel seems a good one. The policymaker has preferences over (variaion in) inflaion and oupu, jus as he consumer has preferences over consumpion now and in he fuure. A decision has o be made how much of oupu and inflaion o have, and he opimal choice will depend on he rade-off ha exiss in realiy beween hem, which is deermined by he srucure of he economy (he AS curve), jus as he consumer s opimal choice will depend on he rade-off beween consumpion now and in he fuure, which is deermined by he real ineres rae. So MRS=MRT, a principle ha is independen of any model, should drive policymakers decisions. The model se ou by Svensson in his 2005 paper does differ from ha which we previously discussed. The mos imporan difference is probably ha he model is forward-looking, i.e. i incorporaes expecaions, which affec curren behaviour. The aggregae supply relaion in S2005 ells us ha he one-period-ahead inflaion plan of he privae secor, π +, depends on expeced fuure inflaion, π + 2 Eπ + 2, he privae secor s oupu gap plan, y +, and privae secor judgemen, z +. π + = E [ π ] + δ ( π + 2 E[ π ]) + α y y+ + α z z+ (5) (Noe ha we have changed noaion compared wih S2005 so ha he oupu gap is represened by y raher han x. We have also moved erm E[π ] o he RHS of he equaion.) π + is he privae secor s plan made in period for inflaion in period +. E[π ] is long run average inflaion. δ is a discoun facor. z + are exogenous random variables and shocks ha cause he simple model above o deviae from he rue model in period +, and z + is he privae secor s expecaion in period of nex period s deviaion. Svensson calls his he privae secor s judgemen. α y is he slope of he shor-run Phillips curve, i.e. he shor-run rade-off beween oupu and inflaion. The previous version of his equaion is reproduced below for comparison purposes:

10 0 π + = π + αy + ε + (5 ) The aggregae demand equaion in S2005 ells us ha he one-period-ahead oupu gap plan depends on he expeced fuure oupu gap, y +2, he expeced one-period-ahead real ineres rae gap, i + π +2 r* +, and privae secor judgemen, z +. * y + = y+ 2 β r ( i+ π + 2 r + ) + β z z+ (6) The real ineres rae gap is he difference beween he naural long-run ineres rae r* (which is he real ineres rae ha would apply in a perfecly-compeiive economy) and he real ineres rae measured by he difference beween he expeced moneary policy insrumen value and he expeced inflaion rae, i + π +2. The previous version of his equaion is reproduced below for comparison purposes: y β y + β i π η (6 ) + = 2( ) + + S2005 assumes ha he cenral bank conducs flexible inflaion argeing, and so has he following ineremporal loss funcion in period : ( δ ) τ E δ L + τ (7) τ = 0 The cenral bank wishes o minimise is expeced discouned loss each period τ from now onwards. The period loss (i.e. loss each period) is: * 2 2 L = [( π π ) + λy ] (8) 2 This is exacly he same as he loss funcion considered previously when he cenral bank cares abou oupu as well as inflaion. If he cenral bank can commi o follow he opimal insrumen pah (i.e. under commimen, as S2005 pus i), he equilibrium firs order condiion ha minimises he cenral bank s ineremporal loss funcion is * λ π + π + ( y+ y ) = 0 (9) α y This is he cenral bank s opimal argeing rule (or opimal specific argeing rule). The previous version of his equaion is reproduced below for comparison purposes: λ Eπ + 2 π* = E y+ (9 ) δα k S2005 also argues ha his rule is a srucural model of moneary policy, o he exen ha he AS and AD relaionships are srucural (and hey are designed o capure opimising price-seing and consumpion choice respecively). As noed above, S2005 argues ha his opimal argeing rule essenially capures he equaliy of MRS and MRT MRS being given by he auhoriies preferences (i.e. he loss funcion, including weigh λ on oupu variabiliy) and MRT by he srucure of he economy (i.e. by he aggregae supply relaionship (5), including he Phillips curve slope α y ). S2005 also argues ha his rule is robus o shocks and judgemen, since he z variables don ener ino he rule.

11 The final advanage of he opimal argeing rule claimed by Svensson is ha i is compac (i.e. small). S2005 is really implying ha argeing rules are more parsimonious han insrumen rules. The example of an insrumen rule he gives (p.69) is he following: * * λ i+ r π + = µ π + π + ( y+ y ) α S2005 would like us o compare his o equaion (9) below; he above is indeed more complex. Differences are he response coefficien µ, and arguably he appearance of he ineres rae. [Noe, hough ha (9) is he argeing rule, no he implici ineres rae reacion funcion derivable from he combinaion of ha rule and he model.]