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Optimal Discretionary Policy vs Taylor Rule: Comparison under Zero Lower Bound and Financial Accelerator

Economic Research Institute (82-2-759-5430) 2010.04.28 872

This paper compares the optimal discretionary policy and the Taylor rule in the
reduced form dynamic new Keynesian model extended with zero lower bound con-
straint and financial accelerator. Financial accelerator causes the fundamental
difference between the two interest rate policy rules: the Taylor rule as a feed-
back rule and optimal discretionary policy as an optimal solution. This makes
the interest rate response to the demand shock to change in an opposite way with
financial accelerator under each policy regime. On the other hand, when the Tay-
lor rule augmented with risk premium suggested by McCulley and Toloui (2008)
and Taylor (2008) is used as a policy rule, the probability that zero lower bound
to bind cannot be ignored. Hence, the welfare effect of augmented Taylor rule is
evaluated with our model. The welfare evaluation result supports their sugges-
tion but the recommended risk premium gap coeffcient in the rule is different
from theirs.


1 Introduction 1

2 Literature Review 4

3 Model 8

4 Computational Method and Calibration 10

5 Computation Results 13
  5.1 Effects of Financial Accelerator  14
  5.2 Effects of Financial Shock  18
  5.3 Welfare Effect of Policy Regimes  24
  5.4 Taylor Rule Augmented with Risk Premium  28

6 Conclusion 32

A Sensitivity tests 38
B Parameter estimation 41