Wicksellian Rules and the Taylor Principle: Some Practical Implications*

• Date: 01 January 2020
• DOI: http://doi.org/10.1111/sjoe.12331
• Published date: 01 January 2020

Scand. J. of Economics 122(1), 340–368, 2020

DOI: 10.1111/sjoe.12331

Wicksellian Rules and the Taylor Principle:

Some Practical Implications*

Sofia Bauducco

Central Bank of Chile, Santiago, Chile

sbauducco@bcentral.cl

Rodrigo Caputo†

Universidad de Santiago, Santiago, Chile

rodrigo.caputo@cantab.net

Abstract

In this paper, we derive and compare the determinacy regions of price-level targeting rules

(Wicksellian rules) and Taylor rules in a standard New Keynesian model. We conclude that

Wicksellian rules do not require the Taylor principle to hold in order to induce determinacy. Our

results have two implications. First,in a univariate setting, the estimation of simple Taylor rules

when the true rule is Wicksellian can lead to the erroneous conclusion that the equilibrium is

indeterminate. Second, indeterminacy is ruled out when using system-based methods, but it can

be concluded that the central bank is less averse to inflation movementsthan it actually is.

Keywords: Determinacy; estimation; monetary policy rules

JEL classification:C62; E31; E52; E58

I. Introduction

Since the influential work of Taylor (1993), Taylor rules have received

widespread attention in the empirical and theoretical literature on monetary

policy. The reason behind this is that these rules are generally considered

realistic yet sufficiently simple representations of how the monetary

authority conducts policy.1In brief, Taylor rules relate – in a linear fashion

*We thank Susanto Basu, Pierpaolo Benigno, Andrea Ferrero, Jorge Fornero, Jordi Gal´ı, Javier

Garc´ıa-Cicco, Gabriel Mathy, Bruce Preston, KevinSheedy, Juan Urquiza, and two anonymous

referees for very helpful suggestions and fruitful discussions. We gratefully acknowledge the

superb research assistance of Mat´ıas Morales and Dami´an Romero. R. Caputo is grateful for

the hospitality of the BI Norwegian Business School during a visiting position held in 2018. S.

Bauducco thanks Anillo in Social Sciences and Humanities (project SOC 1402). All errors are

our own.

†Also affiliated with the Centre for Experimental Social Sciences (CESS), Oxford University.

1See, among others, Clarida et al. (2000) for evidence in the United States, Clarida et al. (1998)

and Lubik and Schorfheide (2007) for estimation of Taylor rules in advanced economies, and

Aizenman et al. (2011) for evidence in emerging countries.

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The editors of The Scandinavian Journal of Economics 2018.

S. Bauducco and R. Caputo 341

– the policy rate to deviations of the inflation rate and a measure of the

output gap. In recent years, price-level targeting (PLT) rules, in which the

policy rate reacts to deviations of the price level instead of inflation, have

regained attention among academics and policy-makers.2,3As in Giannoni

(2014), we refer to PLT rules as Wicksellian rules.4

The objective of this paper is twofold. First, in a standard New

Keynesian model, we derive the areas of determinacy of forward-looking,

contemporaneous and hybrid Wicksellian rules (rules that react to the

expected level of prices and contemporaneous output gap). Second, we

assess the implications of estimating Taylor rules in a context in which the

central bank is setting its policy based on Wicksellian rules. The purpose

of this exercise is to determine the extent to which it is possible to reach

misleading conclusions about the nature of monetary policy if it is not

recognized that the monetary authority is setting policy according to a

Wicksellian rule.

As is well known in the literature, Taylor rules are able to induce

determinacy (see, among others Bullard and Mitra, 2002; Gal´ı, 2008).

Depending on whether the rule reacts to lagged, contemporaneous, or

expected inflation and output, determinacy conditions can change across

alternative Taylor rules. In general, however, determinacy requires a

common constraint for all rules, which is the so-called Taylor principle.

This principle states that the policy rate should react by more than the

increase in inflation, in order to ensure that the real interest rate increases.

Our main findings are as follows. First, in striking contrast with Taylor

rules, Wicksellian rules do not require the Taylor principle5to be satisfied in

2Several elements havecontributed to this fact. Gorodnichenko and Shapiro (2007) show that the

Federal Reserve, in theVolcker–Greenspan era, was behaving consistentlywith having the price

level in its objectives. Theyalso concluded t hat PLT is superior to inflation targeting in a wide

range of situations. Further evidence is provided byBullard (2012) who noticed that prices in the

United States have fluctuated,between 1995 and 2012, around a 2 percent price path. Expanding

the sample from 1991 to 2014 reinforces this finding (see Figure A4 in the Online Appendix).

Reis (2013) reaches a similar conclusion. In the case of Canada, Kamenik et al. (2013) and Ruge-

Murcia (2014) provide similar evidence to that reported in Figure A4. In particular, they show

that, since the mid-1990s, in Canada, consumer prices, inflation expectations, and the policy rate

are determined in a way that is consistent with an element of PLT.

3In a recent contribution, Giannoni (2014) concludes, in the context of a New Keynesian model,

that simpleWicksellian rules perform better in ter ms of welfare,and are more robust t o alternative

shock processes, than Taylor rules. However, Evans (2012) argues that PLT would be a helpful

complement of the FederalReserve’s strategiesin the after math of the 2008 global financial crisis.

4For a more in-depth discussion on the specific proposal by Knut Wicksell and the price

stabilization policies in the 1930s in Sweden, see Jonung (1979) and Berg and Jonung (1999).

5As in Ascari and Ropele (2009), weinter pret theTaylor principle as a policy reaction coefficient

to inflation, which is greater than one, and the generalized Taylor principle as the requirement

that the nominal interest rate is raised by more than the increase in inflation in the long run.

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The editors of The Scandinavian Journal of Economics 2018.