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Application and Extension of the Taylor Rule: the Case of Taiwan

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Application and Extension of the Taylor Rule: the Case of Taiwan Chang, International Journal of Applied Economics, 2(1), March 200, 50-61 50 Estimating the Monetary Policy Reaction Function for Taiwan: A VAR Model Hui S. Chang University of Tennessee – Knoxville Abstract This study examines Taiwan’s monetary policy reaction function based on an extended Taylor rule including the exchange rate, the stock price, and the lagged interest rate. The VAR model is employed to consider simultaneous relations among the endogenous variables. Two major monetary policy instruments - the discount rate and the collateral loan rate - are considered. The results show that within a 95% confidence interval, the discount rate or the collateral loan rate responds positively to a shock to the inflation gap and the stock price gap but does not react significantly to a shock to the output gap or the exchange-rate gap. Furthermore, except for the lagged interest rate, the inflation gap is more influential in explaining the variance of the interest rates than other endogenous variables, suggesting that the major focus of the monetary policy in Taiwan is to contain inflation. Keywords: MPRF, Taylor Rule, output gap, inflation gap, impulse response functions, variance decompositions JEL Classifications: E52, F41, O53 Introduction The Central Bank of China (CBC) in Taiwan monitors the economy through movements in prices, interest rates, employment, exchange rates, business cycles, and other major indicators to formulate its monetary policy. CBC’s monetary policy is to pursue long-term price stability and economic growth and to maintain the dynamic stability of exchange rates. It sets target zones for M2 and M2+bond funds, engages in open market operations, discount window refinancing, and selling of the certificates of deposits (CDs) to mitigate temporary liquidity shortage of financial institutions, and adopts proper measures to counter shocks of any new international developments. In recent years, CBC has maintained easy monetary policy to stimulate consumption and investment spending. On December 31, 2004, CBC increased the discount rate, the rate on loans without collateral, and the rate on loans with collateral by 12.5 base points to 1.75%, 4.0%, and 2.125%, respectively (Central Bank of China, December 31, 2004). CBC predicted that the short-term rates would remain relatively low for the foreseeable future and that it would continue to maintain an accommodative or easy monetary policy. CBC set the target growth of M2 in the range of 3.5% - 7.5% for the year 2005. To strengthen the monetary transmission mechanism, banks have been encouraged to adopt adjustable-rate mortgages (ARMs) and lower prime rates since the mid-2001. CBC also reduced the average required reserve ratio from 6.22% to 5.0%, thus increasing market liquidity considerably. It pursued a Chang, International Journal of Applied Economics, 2(1), March 200, 50-61 51 managed floating exchange rate policy and allowed market forces to determine the exchange rate to some extent. CBC indicates that it will step in to intervene in the foreign exchange market if there are excessive volatility, irregular factors, irrational expectations, market disorder, and/or deviations of the exchange rate from market fundamentals. To avoid a huge loss due to exchange-rate fluctuations, CBC stresses exchange-rate risk management for exporters and importers regularly. For instance, to hedge exchange-rate risk, importers may purchase foreign exchange forwards when placing orders and exporters may sell foreign exchange forwards when receiving orders. This paper attempts to estimate the monetary policy reaction function (MPRF) for Taiwan to determine whether CBC in Taiwan has applied or considered the Taylor rule (1993, 1998, 1999). This paper has several unique aspects. First, following Assane and Malamud (2000), David Romer (2001), Rogobon and Sack (2003), Hsing (2004), and others, this study extends the Taylor rule by considering the exchange rate, the stock price, and the lagged interest rate as additional variables. It is well known that the economy in Taiwan depends heavily on international trade and that the CBC would like to see a dynamic, stable exchange rate, which would be conducive to exports and imports. It is interesting to examine whether CBC uses the interest rates to intervene in the foreign exchange market. It is also worthwhile to test whether CBC responds to stock market performance in order to stimulate aggregate demand and the economy through the wealth effect and the balance-sheet channel. Second, in estimating the MPRF for Taiwan, this paper applies the VAR model in order to avoid simultaneity bias that may exist in the single-equation estimation. Third, the impulse response function and variance decomposition for the interest rates are estimated to find possible responses of the discount rate and the collateral loan rate to a shock to one of the endogenous variables and to determine the explanatory power of each of the variables on the variance of the interest rate. Fourth, U.S. federal funds rate is considered as an exogenous variable to determine whether CBC would react to a shock to U.S. monetary policy. Literature Survey There are several recent articles examining the Taylor rule or the monetary policy reaction function (MPRF) for some industrialized countries. Clarida, Gali and Gertler (1997) estimated MPRFs for G3 (U.S., Germany, and Japan) and E3 (U.K., France, and Italy). Central banks in G3 pursued inflation targeting, were forward-looking, and experienced more success in monetary policy. They showed that interest rates in E3 were greatly higher than what macroeconomic conditions would suggest and that inflation targeting could be a better policy option than fixing the exchange rates. In estimating an MPRF for the U.S. based on a forward- looking model, Clarida, Gali, and Gertler (1998) found that the Volcker and Greenspan administrations were more responsive to expected inflation changes than the pre-Volcker period and that the goal of monetary policy during Volcker and Greenspan was to stabilize output and inflation. Wesche (2003) estimated the MPRFs for five industrialized countries including the U.S., U.K., Japan, Germany, and France. He showed that central banks assigned different weights to the inflation gap and the output gap and that the German interest rate influenced monetary policy in Italy and France after the EMS. Extending the Taylor rule, Hsing (2004) estimated the monetary policy reaction function for Japan and found that the call rate showed a positive response to a shock to the output gap, the inflation gap, stock prices, yen depreciation, Chang, International Journal of Applied Economics, 2(1), March 200, 50-61 52 and the lagged call rate. He also revealed that except for the lagged call rate, the inflation gap and the exchange rate are more important than the other variables in explaining the variance of the call rate. Employing a VAR model to examine the relationship between monetary policy and exchange rates, Assane and Malamud (2000) found that the U.S. dollar appreciated after the federal funds rate rose and that to respond to a weak dollar, the Fed would raise the federal funds rate. According to Kalyvitis and Michaelides (2001), the U.S. dollar was instantaneously overshot due to a monetary shock. Some scholars maintained that the Fed should not consider stock market performance in conducting its monetary policy because it may be counterproductive and difficult to find the correct timing to take actions (Cogley, 1999; Bullard and Schaling, 2002). Rigobon and Sack (2003) showed that monetary policy reacted to stock market performance significantly to cause impacts on aggregate expenditures and that the probability of a 0.25 percentage point increase in the federal funds rate would increase by 50% if there is a 5% increase in the stock price index. Several interesting articles analyzed monetary policy in Taiwan. Emery (1987) reviewed Taiwan’s monetary policy in dealing with the two energy crises and huge trade surpluses since 1973. He found that the tight monetary policy of raising the discount rate due to the energy crises was too small, too late, and not effective in containing inflation. He also suspected that CBC’s open market operations to reduce money supply due to large trade surpluses and capital inflows did not succeed. In studying the monetary reaction function for Taiwan, Shen and Hakes (1995) found that the CBC reacted differently to four inflation regimes, namely, no inflation, low inflation, moderate inflation, and high inflation. Specifically, CBC responded to both inflation and output when there is no inflation, responded to output counter-cyclically and did not respond to inflation when inflation is low, and reacted increasingly to inflation only when inflation is moderate and high. Shen and Chen (1996) developed an index for monetary policy to evaluate the linear and nonlinear reaction functions. CBC in Taiwan responded differently to inflation and output depending upon economic conditions. It would react strongly when inflation and GDP are greater than the threshold levels. Ford (1997) identified different targets of CBC, assigned weights to different targets, and examined tradeoffs. He found containing inflation to be very important to monetary policy. Based on the probit model with correction for autoregression, Huang and Shen (2001) reported that CBC in Taiwan pursued a tight monetary policy during high inflation but not during high economic growth. They also indicated that the simple probit model without correction for autoregression would not be appropriate. Applying the regime switching model, Cheng and Huang (1998) found that CBC followed a non-intervention policy in most cases and maintained a target of monthly money growth in the range of 0.95% to 2.17%. Furthermore, CBC would adjust the discount rate and pursued an easy monetary policy when warranted. Based on a sample during 1978-1999, three different monetary tools and selected targets, Cover, Hueng and Yau (2002) examined whether the discretionary monetary policy or the optimal-rule policy in Taiwan would perform better.
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