Examining the Functions of Central Bank's Reaction Using Taylor's Rule

IntroductionMonetary policies are one category of economic policies. Central banks use monetary policies for reducing inflation and for increasing production, employment and economic rate growth. Implementation of monetary policies can be done as a rule based monetary policy or as a discretionary monetary policy by central banks. Discussion of rule based monetary policy and discretionary monetary policy is of the most important issues of monetary policy making. In the case of discretionary monetary policies, central bank authorities react to their discretion in various economic conditions and based on the various situations of macroeconomic variables such as inflation and economic growth rates. But in the case of systematic monetary policies, central bank authorities will react to fluctuations in the economy, based on economic theory and monetary rules. Estimation of the amount of regulation or discretion of monetary policy is of special importance. Hence, in this study, the issue of rules versus discretion in monetary policies of Iran’s central bank will be examined.
Theoretical Frame workFriedman's (1969) monetary rule is one of the monetary rules based on which regulatory based monetary policies are executed. Friedman's monetary rule was known as the main monetary rule for many years. Friedman believes that in situations where there is uncertainty about the duration of the effectiveness of monetary policy, the discretionary management of the supply of money can increase economic volatility, so he has proposed constant growth monetary rule. Other monetary rules whose application in Iran is investigated in this paper, are Taylor rule and the augmented Taylor rule. Taylor rule and the augmented Taylor rule are the most famous specified reaction function in the economic literature. According to the Taylor rule and the augmented Taylor rule, monetary policymakers react to deviations of output from the potential output and deviations of inflation from target inflation through change in the interest rate as a policy instrument. It is worth noting that due to the rule of interestfree banking system in Iran and due to Iran's central bank’s use of monetary based policies as an intermediate target in monetary policy, in this study, the growth rate of monetary base has been used instead of the interest rate.
MethodologyIn order to examine the amount of regulation of the monetary policies of Iran Central Bank, the following two models were designed
The first model is specification of model for augmented Taylor rule under the first scenario for target inflation:BM = C(1) C(2)*BM(-1) C(3)*GDPGAP C(4)*INFGAP
The second model is specification of model for augmented Taylor rule under the second scenario for target inflation
BM = C(1) C(2)* BM (1-) C(3)*GDPGAP C(4)*INFGAPT
In the above models, BM, BM (-1), GDPGAP and INFGAP are monetary base, the first lag of monetary base, deviations of the actual GDP from potential GDP and deviations of the inflation from target Inflation, respectively. Also, C(1), C(2), C(3) and C(4) are variable coefficients. The above models are estimated using the least squares regression during the period 1974-2013. The results of estimated models are reflected in the results and discussion part.
Results and DiscussionThe results obtained from the estimated equations for central bank's response showed that the coefficient of policy variable of deviations of the actual GDP from potential GDP is significant. But the coefficient of deviations of the inflation from target inflation is not significant. Hence, findings of this research indicate that the behavior of the central bank of Iran with respect to deviations of the actual GDP from its potential is systematic and is based on rule than discretion. But the behavior of the central bank of Iran with respect to deviations of the inflation from target inflation was based on discretion and has not been systematic or rule based during the study period
Conclusion and SuggestionsDetermination of monetary policies based on the discretion instead of determination of them based on rule, often cause inflation and economic instability in Iran. Therefore, in order to reduce social loss of intensifying inflation such as class discrimination and creating appropriate atmosphere for economic growth, the reaction functions of central bank of Iran in response to inflation deviations from its target and deviations of the actual GDP from its potential, is defined. Since lack of central bank’s independence leads to the discretionary behavior, reducing dependency of the central bank to the government is suggested for establishing a systematic behavior in the monetary policies of central banks.