Taylor-type rules versus optimal policy in a Markov-switching economy

Abstract

We analyse the effect of uncertainty concerning the state and the nature of asset price movements on the optimal monetary policy response. Uncertainty is modeled by adding Markov-switching shocks to a DSGE model with capital accumulation. In our analysis we consider both Taylor-type rules and optimal policy. Taylor rules have been shown to provide a good description of US monetary policy. Deviations from its implied interest rates have been associated with risks of financial disruptions. Whereas interest rates in Taylor-type rules respond to a small subset of information, optimal policy considers all state variables and shocks. Our results suggest that, when a bubble bursts, the Taylor rule fails to achieve a soft landing, contrary to the optimal policy.