Working Paper

What Do Reaction Functions Tell Us About Central Bank Preferences?

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Since Taylor’s 1993 paper researchers have devoted a lot effort to
estimation of monetary policy rules. Taylor showed that a simple central
bank reaction function, with the interest rate as monetary policy
instrument and inflation and output gap as explanatory variables,
mimics the Fed funds rate pretty well during the period from 1987 to
1992. Often, the Taylor rule coefficients are interpreted as if they reflect
central bank’s preferences. However, this may be misleading. In
this paper we show that Taylor rule coefficients are complicated terms
consisting of preference parameters as well as parameters given by the
structure of the economy. We illustrate our conclusion that Taylor rule
coefficients cannot be interpreted as reflecting central bank preferences
by estimating standard forward-looking Taylor rules for the Bundesbank,
the Fed and UK and confront these with our results obtained
by a multi-equation GMM approach in order to detect central bank


Steffen Elstner
Amer Tabaković


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