Longer-term output forecasts will be more accurate under a Taylor rule than
under the optimal policy. The lack of aggressiveness of the Taylor rule in
the event of an asset price boom-bust episode is also evident on Table 5: the
conditional volatility of the real interest rate is always lower under the Taylor
rule, i.e., the real interest rate will be harder to forecast under the optimal
policy.
4 Conclusion
In this paper we tried to give an answer to the following question: Given the
possibility of an asset price bubble burst and a subsequent hard landing, what
is the optimal monetary policy reaction? When asset prices are driven by
non-fundamental shocks, both the optimal policy and the Taylor rule seem to
suggest that central banks should keep increasing the real interest rate, and to
decrease it sharply when the bubble bursts. However, the Taylor rule suggests
a lower increase in the real interest rate. The sharper movements in the real
interest rate induced by the optimal policy suggest that the standard Taylor
rule may be not aggressive enough in the event of an asset price boom-bust
episode.
Our results suggest that overall Taylor-type rules may be very effective at
stabilizing output and the real interest rate. However, they also indicate that
if central banks do care about output future’s path and aim at a softlanding
— which according to (Meyer 2004), (Greenspan 2007) and (Woodford 2007)
seems to be the case — following a bubble burst they increase liquidity more
than the Taylor rule prescribes. These conclusions seem to be in accordance
with previous findings in the literature on monetary policy and asset prices
(Mishkin 2007) and suggest that further research on the relation between
deviations from the Taylor rule and volatility in financial markets may be
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