The application of Taylor’s Rule and effect on monetary policy globally.

Looking at the numerical form, the rule is written down as:  i = r * +π * +1.5 (π −π *) + 0.5 y, where i stand for the nominal policy rate, r* is represented as the long run, π * is represented as the inflation rate posed by central bank, π is the inflation rate at the current period and y is the output gap in the current period (Svensson, 2012).

The rule inherently applies that stabilization of inflation is done by the central banks through inherent output and target levels around its particular potential target. Positive deviation, which implies negativity inherently from two stated variables would subsequently lead to loosening the monetary policy the figures below illustrate the application of the Taylor’s rule and the policy rates globally, in advanced economies and in emerging market economies.

Figure 1: Application of Taylor rule to global policy rates (Taken from Hofman and Bogdanova, 2012).

Figure 2: Application of Taylor Rule to advanced economies (Taken from Hofman and Bogdanova, 2012).

Figure 3: Application of Taylor Rule to emerging market economies (Taken from Hofman and Bogdanova, 2012).

The assignment highlights through the application of practicable monetary models and rules an application and distinct use of both the flexible approach and the discretionary approach. The essay begin with definition of inflation targeting then goes into a discussion regarding the discretion versus flexibility approach which is a continuation of the introduction on Taylor’s rule which inherently is amalgamated with various further rules applied (Bernanke, 2010). The essay then goes on give a concluding paragraph while highlighting the benefit of either of the approaches: flexibility and discretion in light of the current global monetary crisis.

 Inflation targeting.

Inflation targeting has become a popular economic policy that has allowed the central bank to actyally give a preduetc target of inflation and then following the prediction makes efforts to ensure that the real inflation rate comes up or goes down to the predicted target inflation. (Hammond, 2011). The relationship observed between inflation and interest is known to be inverse; therefore, where the inflation rates is subsequently higher than the predicted amount, the banks will most likely increase the rate of current interest, subsequently where the interest rates are lowered the inflation is also seen to drop as well. This approach or monetary tool is seen by many to be as an economic stabilizing agent. The global financial crisis highlighted amongst other things that any one internal factor was not a reason attributed towards the crisis and whereby without considering the global situation if countries play around with the interest rates then they will be at a disadvantage (Hannoun, 2012).

Discretion versus flexibility.

There has been sufficient emphasis on the use of policy rules within the recent macroeconomic research especially before the global financial crisis.  This section analyses various forms of discretionary and fixed monetary policy rules following which their benefits and consequential acceptance will be illustrated.

In comparison to the discretionary policy, the Fixed monetary policy rule has been designed in terms of a target policy achieving goal that has been set by the government, and then therefore is followed invariably without justification. It constituents the various monetary policy tools that have been seen to be applicable throughout the crisis globally. Taylor’s Rule is one such example which has been discussed in the section above. Another popular monetary policy rule, following the application of Taylor Rule is the Friedman Rule which requires the interest rate to be set at zero. It requires a balance to be maintained between the social and the opportunity cost thereby, both must be equal in terms of fiat money. This simply means that the central bank is aiming at deflation which is subsequently at the same standing as interest rates which can be compared through safe assets. The application of this Rule is seen to be a welfare maximising policy in various models of the economy, and has been pointed out by Hannoun, 2012, that in order to achieve optimum results interest rate can be increased or decreased from zero accordingly. The same optimal results can be invariably achieved by the eliminating the interest rates between the nominal policy interest and the interest on subsequent revenues to ensure that the rates achieved are actually equal at all times.

Conclusion.

Macro prudential policy adoption has been advocated by the G20 leaders as well as the financial stability board. Haldane, 1995, states that there is a need to statistically and systematically analyze any shortcoming that is a consequence of the macro factors which aims at the production of a pro cyclical approach which as pointed out by Gambacrota et al, 2012, will support sustainable growth.

Where it may be practicable to use a discretionary policy post financial crisis, a primary reason being that the application of fixed rules did not bring about the desired result but in fact was a constituent of the failing monetary policy, however, keeping in mind the trade off between ex ante efficiency of the discretionary policies, the ex post efficiency of the fixed rules, a hybrid monetary policy which constrains discretion has been adopted in the monetary policy mechanisms (Merrouche and Niar, 2010). The central bank in response to any potential pitfalls of the discretionary monetary policy has chosen the public reaction function approach which is not only clearly stated but ensures transparency and accountability of the decision making process.

This clearly indicates the preferences of the central bank and monetary institutions in using these mechanisms primarily through a hybrid strategy which inherently seems practicable in the face of such a crisis, but whose only success can be judged by the use application of the same policy in long term.