The Taylor rule : how well does the interest rate set by a common central bank match the optimal rate for individual countries as predicted by the Taylor rule?

The Taylor Rule

How well does the interest rate set by a

common central bank match the optimal rate

for individual countries as predicted by the

Taylor rule?

Bachelor Thesis Economics & Finance

Abstract

This paper analyses whether the interest rate set by a common central bank matches the interest rate that would be optimal for individual countries predicted by the Taylor rule. Using this rule, the interest rate for the euro area is calculated to see whether it matches the interest rate set by the European Central Bank. The finding is that this is true. In order to find out whether this is the case for individual countries the same calculations are made for a selection of euro area countries. Unfortunately, the interest rates for these individual countries as predicted by the Taylor rule do not match the common interest rate set by the European Central Bank.

Author: Martijn Schaaf Student number: 10360557

Supervisor: Mr. C.G.F. van der Kwaak MSc Date: 7 October 2015

Statement of Originality

This document is written by Student Martijn Schaaf who declares to take full responsibility for the contents of this document.

I declare that the text and the work presented in this document is original and that no sources other than those mentioned in the text and its references have been used in creating it.

The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents

TABLE OF CONTENTS

LIST OF GRAPHS AND TABLES ... 4

I. INTRODUCTION ... 5

II. LITERATURE REVIEW ... 6

III. METHODOLOGY ... 9

IV. RESULTS ... 15

I.

EURO

AREA ... 15

II.

GERMANY ... 16

III.SPAIN ... 20

IV.THE

NETHERLANDS ... 22

V. CONCLUSION ... 24

VI. BIBLIOGRAPHY ... 27

VII. APPENDIX ... 30

LIST OF GRAPHS AND TABLES

III. METHODOLOGY

GRAPH 1: ECB MAIN REFINANCING RATE ... 13

GRAPH 2: CORE INFLATION ... 14

GRAPH 3: UNEMPLOYMENT GAPS ... 14

GRAPH 4: OUTPUT GAPS ... 16

IV. RESULTS

GRAPH 5: EURO AREA ... 17

GRAPH 6: EURO AREA * ... 18

GRAPH 7: GERMANY ... 19

GRAPH 8: GERMANY * ... 19

GRAPH 9: SPAIN ... 20

GRAPH 10: SPAIN * ... 24

GRAPH 11: THE NETHERLANDS ... 25

GRAPH 12: THE NETHERLANDS * ... 26

TABLE 1: CORE INFLATION RATES ... 20

TABLE 2: UNEMPLOYMENT GAPS ... 21

TABLE 3: REAL GDP GROWTH ... 23

VII. APPENDIX

GRAPH 13: EURO AREA INFLATION ... 32

GRAPH 14: INFLATION DEVIATION FROM ECB TARGET ... 32

TABLE TAYLOR OPTIMAL RATES ... 33

* GRAPHS 6, 8, 10 AND 12 INCLUDE A MORE COMPREHENSIVE VERSION OF THE TAYLOR RULE.

I. Introduction

After the creation of the European Monetary Union on the first of January 1999, the full control of monetary policy decision-making was transferred from each individual country to a new institution: the European Central Bank (Bean, 1998). Since then the ECB has been responsible for monetary policy in the euro area and its statues define price stability as the ECB’s primary objective (Fendel & Frenkel, 2006). The

objective was specified more precisely by the ECB (1998, p. 1) as the “year-on-year increase in the Harmonized Index of Consumer Prices (HICP) for the euro area close to but below 2%”. Fendel and Frenkel (2006) state that price stability should be kept over the medium term since monetary policy is not able to adjust for price changes over short time periods.

A 2004 study by Fourçans and Vranceanu analysed ECB behaviour in the period from the time of the introduction of the euro until the end of 2003. Their analysis indicates that the ECB is taking the level of inflation into account when setting the short-term interest rate: it increases the short-term interest rate if inflation deviates from its target (Fourçans & Vranceanu, 2004). The Maastricht Treaty, which contains the Euro system goals, sets forth that the ECB should support the general economic policies (Article 105) in the Eurozone without harming the first goal of price stability (Dominguez, 2006). Gerdesmeier, Mongelli, and Roffia (2007) state that this main goal has been achieved since January 1999, with average inflation close to or somewhat above 2%.

However, as de Haan and Berger (2010) along with Fendel and Frenkel (2009) point out in their work, inflation rates in the different countries within the euro zone did not converge and cross-country differences in inflation rates have been persistent and considerable. These differences between countries are not desirable because the ECB reacts to inflation in setting its short-term interest rates and since the inflation rates are not the same across countries this hints for the possibility of a non optimal common interest rate as well: different levels of inflation require different interest rates instead of a common rate. The need to investigate whether setting a common interest rate is optimal for individual countries now becomes more relevant. To find out if the common rate set by the ECB is optimal for individual

countries, this paper examines whether a simple equation based on the original Taylor rule could be used in order to do so.

The Taylor rule, as proposed by John Taylor (1993), calculates an interest rate target that would be optimal based on just a few variables. The simple equation based on the original rule has been proposed by Nechio (2011), which calculates a target rate based on inflation and the difference between the measured- and structural unemployment rate. This version will be used for simplicity but in order to test the validity of this simple model a more comprehensive version of the Taylor rule will be analysed as well.

Research based on this topic already exists but is not performed for individual countries within a monetary union. Therefore, in this paper it will be investigated whether setting a common interest rate in a monetary union is optimal for individual countries within the union as judged by the Taylor rule. Hypothesizing using the above it will be expected that even though the Taylor rule's recommended rates might align with the ECB’s rate for the euro are as a whole, it will not for individual

countries because inflation rates differ across countries and require different interest rates.

The rest of this paper is divided in four parts: the next part will review existing literature on this topic, the third part explains how research is conducted, the fourth part what the results of the conducted research are and the final part contains the conclusion and a discussion.

II. Literature Review

Many papers have been published which investigate whether the Taylor rule is effective in setting the interest rate. These papers were however published decades ago and although they cover a great amount of knowledge on this topic, only the most important will be used and thus the literature review of this paper focuses more on papers published this century.

From the introduction it followed that even though the ECB does achieve its goal of price stability, cross-country differences are considerable. These persistent and considerable differences in inflation rates across members of the Eurozone, together with the low inflation objective of the ECB, may lead to periods of deflation and common monetary policy may loose its usefulness (Morana, 2006). These deflationary risks to the ECB’s main objective are supported throughout recent other studies as well (Coenen & Warne, 2013; Bordo & Filardo, 2005). Although inflation

rates started to converge when the project of the European Monetary Union entered its critical stage in the 1990s until the adoption of the euro in 1999, euro area inflation rates started to diverge again afterwards (Cavallero, 2011). These studies show cross-country differentials and the fact that inflation divergence occurs, which also indicates the need for increased cautiousness in determining a single interest rate for the euro area countries because the simple Taylor rule version uses inflation as one of its variables.

The divergence of inflation rates is not uncommon in a monetary union with a single currency because, in the case of a fixed exchange rate regime and low labour mobility, they play the role as market adjustment instrument in response to macro-economic shocks to the economy (de Haan & Berger, 2010). Since the divergence of inflation rates are considered to be important for automatic adjustment to economic shocks they will be taken into consideration to explain the current ECB’s policy stance. Factors that cause inflation differentials across euro area countries are listed by Fendel and Frenkel (2009) and are similar to the ones (de Haan & Berger, 2010) proposed. The first factor proposed by them is about the process of convergence amongst euro area members: countries had different price levels before joining the euro area which caused temporary differences of inflation. Secondly, permanent factors related to national economic structures could have also contributed to inflation differentials (Fendel & Frenkel, 2009). These differentials arise from the possibility that consumers have different preferences across countries. Furthermore, the increase of the prices of imported goods is an example of another structural factor. Countries within the euro area respond differently to an increased price of imported goods because their response depends on their degree of openness and thus they face different inflationary pressures (Fendel & Frenkel, 2009). The final reason argued by Fendel and Frenkel (2009) causing differences arises from policy-related factors. In addition to these factors, de Haan and Berger (2010) include a fifth factor: wage and price rigidity. They add that these factors are not mutually exclusive since for example the impact of shocks on inflation differentials depends on wage and price rigidities. Furthermore, according to Beck, Hubrich and Marcellino (2009),

differences in inflation can cause welfare losses if they are the result of economic distortions and this in turn might be an undesirable consequence for the way an authority sets is monetary policy.

common central bank matches the optimal rate for individual countries as judged by the Taylor rule. Peersman and Smets (1999) examined the Taylor rule as a simple policy guideline shortly after the introduction of the Eurozone in 1999 and found that it performed better for the United States economy then for the euro area, regardless of the fact that regional differences arise in the United States as well. They also conclude that the rule estimates the policy performance of central banks quite good, but remark that it would be a too restrictive model since central banks want to respond to other indicators as well. On the contrary, the model can be used as a benchmark to assess policy decisions, which are based on the widest information set available, and as communication device to explain policy decisions to the general public (Peersman and Smets 1999).

Since their research and the creation of the euro area the amount of research on the Taylor rule and its usefulness as monetary authority’s recommendation tool has increased. Even though research by Peersman and Smets (1999) showed that the Taylor rule performs better for the United States then for the euro area, later findings by Belke and Polleit (2007) show that the short-term interest rate and Taylor rate moved closely between 2001 and 2005 for the euro area as well. This suggests that the ECB’s policy could be described using the Taylor Rule. Moons and van Poeck (2008) show that a simple version of the Taylor rule can indeed describe the ECB’s policy. Again, this simple version of the rule is also comprised of inflation and unemployment (Rudebusch, 2010).

Nechio (2011) uses this simple rule and concludes that a single interest rate in a monetary union is not likely to match the rate that would be optimal for every individual country according to this rule. She argues that the ECB’s target rate is aligned with the Taylor rule rate for the euro area in common, but not for the separate countries within the union. Plotting the unemployment gap and inflation for

individual euro area countries led to the conclusion that a clear divergence in effectiveness of the Taylor rule exists between the peripheral euro area members Greece, Ireland, Portugal and Spain and the core European countries of Austria, Belgium, France, Finland, Germany and the Netherlands (Nechio, 2011). The peripheral countries have larger unemployment gaps and inflation varies more in the peripheral countries (Nechio, 2011). Finally, she concludes that the ECB’s short-term interest rate target has been below the anticipated Taylor rule rate for peripheral

countries and more in line with the Taylor rule target rate for the core euro area countries from the introduction of the euro until the financial crisis of 2008. Besides this simple backward looking version of the Taylor Rule used by Nechio in 2011, Clarida, Gali, and Gertler (1998) proposed a ‘forward looking’

version of the rule in which it is taken into account that a central bank accounts for the difference between expected inflation and output and their corresponding targets when setting the interest rate. Expectations are not only considered to be an essential part of monetary policy setting in the work of Clarida et al. (1998), but also in more recent publications by the ECB (ECB Forward guidance, 2014). Because for example the public’s important economic decisions like investment and durable consumption depend on their expectations of how the interest rate will evolve, expectations are also a determinant of the effect of monetary policy on the economy (ECB Forward

guidance, 2014). Clarida et al (1998) estimated the coefficients of the Taylor rule for two groups of countries: Germany, Japan and the United States (G3), and the UK, France and Italy (E3). Because the G3 major central banks all started to focus on controlling inflation around 1979, they used data from 1974 till 1993 to characterize empirically how these banks conducted monetary policy. They found that the

estimated version of the rule did closely match the nominal short-term interest rate set by the G3 central banks.The same time frame was used for the E3 central banks but results have to be taken into consideration with caution since the central banks of these countries were constrained by their European Monetary System (EMS) commitments to fix their exchange rates and remove capital controls. In addition, these banks were highly influenced by the Bundesbank of Germany because the Bundesbank was determining the monetary policy for Europe (Clarida et a., 1998). This suggest that interest rate setting by the Bundesbank would not be optimal for France and the UK because its central banks would prefer to set a rate conditional on the state of its own economy. To isolate the E3 banks from these constraints Clarida et al. (1998) used the policy setting of the German Central Bank as reference and found that, at the time the EMS collapsed, interest rates for every E3 country were higher than domestic macroeconomic conditions justified as measured by the

estimated version of the rule. Finally, Clarida et al. (1998) conclude that because the estimated version did only seem to match interest rate setting behaviour of the G3 central banks, this suggest that targeting inflation is a good way to set monetary

policy for central banks of countries that are not influenced by other central banks. Inflation targeting means raising nominal interest rates to increase real interest rates when expected inflation moves above its long-run target.

The literature shows that the ECB has achieved its primary goal on price stability for the euro area.However, inflation rate differentials between countries within the euro area are persistent and considerable.Although the divergence of inflation rates is not uncommon in a monetary union with a single currency, differences in inflation can cause welfare losses if they are the result of economic distortions and this in turn is an undesirable consequence for the way monetary policy is set by an authority like the ECB. The original Taylor rule as proposed by John Taylor (1993) recommends a target rate that is based on the inflation rate and the output gap. The simple version used in this paper is the same version Nechio (2011) used and uses the difference between measured- and structural unemployment instead of the output gap. Since one of its components is the inflation rate these differentials must be taken into consideration to study whether setting a single rate for the euro area is optimal for individual euro area countries, judged by the simple version of the rule. The Taylor rule's usefulness in describing interest rate setting by the common central bank has been researched thoroughly and several researchers found that it performed better with the Fed’s policy then for the ECB. Despite these conclusions later research by Belke and Polleit (2007) showed that the Taylor rule recommended rate did match the common rate set by the ECB in the period between 2001 and 2005, which is in line with the work of Nechio (2011) that the rate set by the ECB matches the rate that would be optimal for the euro area as a whole according to the Taylor rule. Further research states however that it cannot be used for a monetary union like the euro area as a whole since cross-country differences are present. The concluding remark from Nechio (2011) is that a distinction can be made for core and periphery countries.

Finally, Clarida et al. (1998) show that expectations are considered to be important for monetary policy, and thus interest rate setting, and that a forward looking Taylor rule based on this finding tracks the nominal short-term interest rate set by the G3 major central banks better than for the E3’s due to certain constraints. Empirical research will be performed in the next section to find out whether the common short-term interest rate set by the ECB matches the optimal rate for individual countries according to the simple version of the Taylor rule.

III. Methodology

To analyse whether the common short-term interest rate set by the ECB matches the rate that would be optimal for individual countries as calculated using the Taylor rule, the simple version of the rule will first be explained. Hereafter, it will be made clear how required data is collected and how adjustments are done in order to correspond all data correctly and make calculations based on the simple version of the rule. Afterwards will be explained which of these calculations will be used in order to examine if the Taylor rule optimal rates match the common rate set by the ECB. After all this done, another version of the Taylor rule will be chosen and explained in order to do a robustness check on the effectiveness of the simple version.

Although the literature review discussed that the forward looking Taylor rule proposed by Clarida et al. (1998) performs better then a simple version of the Taylor rule, more recent work by Moons and van Poeck (2008) showed that a simple version of the Taylor rule can indeed describe the ECB’s policy for interest rate setting. The simple version of this rule proposed by Rudebusch (2010) uses inflation and

unemployment and is analysed for several euro area countries by Nechio (2011). Since these findings support the possibility that a simple version could be used to analyse if the Taylor rule recommended rates match the short-term interest rate, this thesis will examine this using the simple version used by Nechio (2011):

!"#$%& ("&% = 1 + 1,5 × /012"&340

− 60%782497%0& $"8 (1)

According to this simple rule, the interest rate should respond to deviations of inflation from its target and measured unemployment from its natural rate (Rudebusch, 2010). The natural or structural rate is the rate that “would cause

inflation neither to decelerate nor accelerate.” (Nechio, 2011, p.1). The inflation is the rate of growth of the consumer price index (CPI). The inflation that will be used here is core inflation and is favourable for monetary policy because it differs from headline inflation in the fact that it does not represent movements in food and energy prices and is therefore more volatile than the core CPI inflation rate (Bodenstein, Erceg & Guerrieri, 2008). Research conducted is based on the work of Nechio (2011), who made a distinction between core countries Austria, Belgium, France, Finland,

Germany and the Netherlands, and periphery countries Greece, Ireland, Portugal and Spain. Instead of making a distinction between core- and periphery countries I will examine whether the Taylor rule’s target rate for some particular countries within the euro area, and for the euro area as a whole, match the ECB’s short-term interest rate. The chosen countries are countries from both the core and periphery groups, namely: Germany, Spain and the Netherlands. Since these countries are not from the same group, differences among these countries are likely to exist. Germany was chosen because the literature review showed that mainly Germany controlled monetary policy for Europe, which suggest that its optimal rate as calculated by the Taylor rule would match the rate set by the ECB. Another core country, the Netherlands, was chosen because it is a small country compared to Germany and might be under its influence. Another individual country that is chosen is Spain because it represents a peripheral country that is not as heavily debated as Greece. The chosen time frame is from the first quarter of 2001 until the last quarter of 2014. This time frame not only covers periods of relative economic stability but also of relative economic instability because it contains the financial crisis and does not reach beyond the existence of the ECB. Two periods are distinguished here: from 2001 to 2007 and from 2007 to 2014 to see if the rule’s calculations would better match the rate set by the ECB in a certain period.

As can be derived from the paragraph above, in order to create target rates using the simple rule for Germany, Spain and the Netherlands, the core inflation-, measured unemployment- and structural-, or, natural unemployment rates are needed. Besides these simple Taylor rule’s parameters, the ECB’s nominal short-term interest rate data is also needed in order to compare the computed Taylor rule rate with the ECB short-term interest rate.

Data on these parameters has been gathered from the websites of the

Organization for Economic Co-operation and Development (OECD), the European Central Bank (ECB) and Eurostat. Data on the ECB’s nominal short-term interest rate, also called ‘main refinancing rate’, is published throughout the year on the ECB’s data website. Because most of the data on variables is only published quarterly, the rate that would be optimal using the simple Taylor rule version is calculated using quarterly values throughout this paper. Not all data is published quarterly, so for example data that is published monthly is averaged out to create a value for each quarter. This method is used throughout this paper for both the simple

model and the later to be introduced more comprehensive model. Differences in the basis of publications of data can be considered as drawback in the calculation for a single quarterly Taylor rule target because taking averages is not the same as using data on the same basis. However, since not all variables have quarterly data available this cannot be overcome. The resulting ECB values on its quarterly nominal short-term interest rate are shown in graph 1.

Source: ECB-website. This graph represents the ECB’s main refinancing rate from 2001 to 2014. The vertical line marks the specified periods of stability from 2001 to 2006 and relative instability from 2007 to 2014.

The first variable data needed for the simple version of the Taylor rule is inflation. Headline inflation excluding food and energy prices forms core inflation and was extracted for all three countries and the euro area as a whole from the OECD Data website, as is displayed in graph 2. The horizontal line at 2% is the ECB’s target inflation rate, which is set at 2%. Data from the OECD has been used on core

inflation for the euro area’s members between the first quarter of 2001 and the last quarter of 2014. In order to show the volatility differences of headline- and core inflation the ECB’s headline- and core inflation are accounted for in graph 13 in the appendix. The second part of the simple version of the Taylor rule consists of the unemployment gap: the difference between the measured unemployment rate and the structural, or ‘natural’ unemployment rate. The measured and structural

unemployment rates have been extracted from the OECD data website. Data on the euro area as a whole was only available from 2003, so 2003 onwards is used. This

0,0% 0,5% 1,0% 1,5% 2,0% 2,5% 3,0% 3,5% 4,0% 4,5% 5,0% P er ce nt age Year-Quarter

Graph 1: ECB Main Refinancing Rate

implies that the time frame for the analysis of the euro area changes to the first quarter of 2003 until the last quarter of 2014. Finally, the structural unemployment rates were subtracted from their measured rates for each country, resulting in graph 3.

Source: OECD DATA. This graph represents the core inflation values for Germany, Spain, the Netherlands and the euro area from 2001 to 2014, as well as the ECB’s target inflation value. The vertical line marks the specified periods of stability from 2001 to 2006 and relative instability from 2007 to 2014.

Source: ECB, OECD DATA, OECD World Economic Outlook. This graph represents the unemployment gaps of Germany, Spain, the Netherlands and the Euro area as a whole from 2001 to 2014. The vertical line marks the specified periods of stability from 2001 to 2006 and relative instability from 2007 to 2014.

-0,5% 0,0% 0,5% 1,0% 1,5% 2,0% 2,5% 3,0% 3,5% 4,0% 4,5% P er ce nt age Year-Quarter

Graph 2: Core Inflation

Germany Spain the Netherlands ECB Target Euro Area -6% -4% -2% 0% 2% 4% 6% P er ce nt age Year-Quarter

Graph 3: Unemployment Gap

Germany Spain

the Netherlands Euro area

Having all data available, the simple version’s interest rate can be calculated which is done for each chosen individual country and the euro area in the next section: results. Above method will be performed again using a more comprehensive version of the Taylor rule in order to test the robustness of the simple version. The model used to this is the general version of the Taylor rule:

3_< = =_< + 0,5 9_?@<,< − 9_AB<,< + 0,5 =_< − =_<?CDE< + # (2)

This formula is used to calculate 3<, which also is the proposed short-term nominal interest rate target at time t. However, it consists of different features than the simple version: =_< is the measured (core) inflation rate at time t, 9_?@<,<− 9_AB<,< the difference between the actual real gross domestic product (GDP) and its potential real GDP at time t, =_<?CDE< the target inflation which is set by the ECB at two percent and r the “equilibrium” real interest rate (Taylor, 1993). This formula has been used to compute all time series data for Germany, Spain, the Netherlands and the euro area as a whole. The resulting graph for the difference between measured inflation, =_G, and the ECB’s two percent target is presented in graph 14in the appendix and is almost the same as graph 2 but now subtracted by the ECB target to better show its deviations from zero and thus its target. From the formula it follows that if inflation rises above the ECB’s target of two percent, the Taylor rule target rate also rises. It also follows that if the measured core inflation rate and the actual real GDP are higher (lower) than the inflation target and potential real GDP respectively, this would imply a higher (lower) short-term interest as recommended by the Taylor rule which means that in this example it would require a more restrictive (more accommodative) monetary policy. Restrictiveness of monetary policy can be illustrated using an example: suppose the ECB decides to raise the short-term interest rate, this would mean for consumers that they become restricted because lending and spending become less attractive since saving now yields a higher interest rate.

Except the variables already used in the simple version, the real equilibrium interest rate and the difference between real- and potential GDP, also named ‘output’ gap, are problematic. This equilibrium real interest rate could be calculated by taking an average of interest rates from a set of yearly values but this would not result in a precise value, certainly not for the euro area as a whole. Therefore, a constant value of

two percent will be used, as was used by Taylor (1993). In order to calculate the output gap, data on actual and potential GDP will be extracted from the Eurostat website by using ‘chain linked volumes’, which means real data because it only reflects changes in the amount of output instead of price effects as well. Subtracting both extracted data sets on GDP yields the output gap for each country and the euro area. The output gaps are plotted in graph 4 and it becomes clear that although they move roughly in the same direction throughout the business cycle, differences between countries are large. For example, at the beginning of the sample the output gap of Spain is two percent higher than the output gap of Germany and one percent higher than the output gap of both the Netherlands and the euro area. These positive differences flip from the first quarter of 2011 until the end of the sample and the difference between Spain and Germany even widens to five percent.

Since all data has been prepared for both the simple- and more comprehensive model’s variables the next section will be used to show the results of combining all variables for their corresponding model. The results will be separated in the results of Germany, Spain and the Netherlands, and the euro area as a whole. In order to ensure readability, the comprehensive model is also shown in graphs 6, 8, 10 and 12.

Source: Eurostat. This graph represents the output gaps of Germany, Spain, the Netherlands and the Euro area as a whole from 2001 to 2014. The vertical line marks the specified periods of stability from 2001 to 2006 and relative instability from 2007 to 2014.

-6% -4% -2% 0% 2% 4% 6% Pe rc ent age Year-Quarter

Graph 4: Output gaps

Germany Spain

the Netherlands Euro area

IV. Results

In order to see whether the common interest rate set by the ECB matches the optimal rate as judged by the Taylor rule, calculations are performed for the euro area first using the method described in previous section. The results are displayed in graph 5 and suggest that the interest rate set by the ECB is too low compared to the optimal rate as suggested for the euro area by the Taylor rule. The same holds true for the more comprehensive version in graph 6. Although the interest rate set by the ECB seems too low during the time frame, the difference between the optimal rates calculated by the simple and more comprehensive version with the ECB target rate becomes no more than two percent. Since they also move in the same direction, the graphs both suggest that the ECB’s interest rate matches the Taylor optimal rates for both versions of the rule for the euro area.

Source: ECB, OECD DATA, OECD World Economic Outlook. This graph represents the Taylor rule’s target interest rate for the euro area, along with the ECB’s short-term nominal interest rate. The vertical line marks the specified periods of stability from 2001 to 2006 and relative instability from 2007 to 2014.

So, most notably is that the Taylor optimal rate is higher than the ECB’s short-term interest rate for almost every quarter. Furthermore, it has roughly the same shape and

0% 1% 2% 3% 4% 5% 6% Pe rc ent age Year-Quarter

Graph 5: Euro area

Taylor simple ECB target

closely matches the calculations for the simple and comprehensive version. Further investigation is required to find out whether the same is the case for the selected individual countries.

Source: ECB, OECD DATA, OECD World Economic Outlook, Eurostat. This graph represents the simple- and comprehensive Taylor rule’s target interest rate for the euro area’s nineteen members, along with the ECB’s short-term nominal interest rate. Countries have been weighted according to their real GDP. The vertical line marks the specified periods of stability from 2001 to 2006 and relative instability from 2007 to 2014.

ii. Germany

In order to see if the Taylor rule target for both the simple and more comprehensive version aligns with the nominal short term interest rate set by the ECB, calculations are made with all data corresponding from 2001 to 2014 for the first chosen

individual country: core-country Germany. Calculations are based on the previous section and the results are displayed in graph 7 and 8 on the next page.

From graph 7 it becomes clear that the simple rule’s proposed short-term interest rate target does generally not come close to the ECB target. These results are very

different from the results of the euro area with differences of nearly four percent. The only pattern that does seem to exist is between 2006 and 2008, where both rates increase. Another clear distinction can be made between the chosen time periods of relative stability and instability. While having a relatively stable economy, between 2001 and 2006, the recommended rate remains below the ECB’s target rate.

0% 1% 2% 3% 4% 5% 6% Pe rc ent age Year-Quarter

Graph 6: Euro area

Taylor simple Taylor comp. ECB target

Source: ECB, OECD DATA, OECD World Economic Outlook. This graph represents the Taylor rule’s target interest rate for Germany, along with the ECB’s short-term nominal interest rate. The vertical line marks the specified periods of stability from 2001 to 2006 and relative instability from 2007 to 2014.

Source: ECB, OECD DATA, OECD World Economic Outlook, Eurostat. This graph represents the simple- and comprehensive Taylor rule’s target interest rate for Germany, along with the ECB’s short-term nominal interest rate. The vertical line marks the specified periods of stability from 2001 to 2006 and relative instability from 2007 to 2014. -1% 0% 1% 2% 3% 4% 5% 6% Pe rc ent age Year-Quarter

Graph 7: Germany

Graph 8: Germany

On the contrary, during a period of relative instability from the beginning of 2007 to 2014, the simple Taylor rules’ target for Germany remains above the ECB’s rate with at least one percent from the first quarter of 2009 until the end of 2014 in which the difference has become four percent. This means that in the first period the ECB’s target was too strict and too accommodative for the second period for Germany. Even though the more comprehensive Taylor model shown in graph 8 seems to better align with the ECB short-term nominal interest rate, this version seems to suggest that for almost every quarter in the second period the ECB interest rate was too low for Germany. The questions that arise are: what causes these large differences and why does it seem as if the relation between the two has inversed between the two periods of relative stability and instability?

One explanation for the low simple version’s recommended rate in the first period might be that Germany had relatively low levels of core inflation, which is clearly visible in table 1.

Table 1: Core Inflation rates in percentages Germany Spain Netherlands,

the Euro Area (19 members) 2001 1,02 3,51 3,69 1,84 2002 1,57 2,83 3,40 2,40 2003 0,96 2,90 2,12 1,79 2004 1,72 2,43 1,63 1,86 2005 1,07 2,48 1,30 1,41 2006 1,06 2,75 0,53 1,42 2007 1,93 2,45 1,46 1,89 2008 1,40 2,33 1,78 1,85 2009 1,25 0,80 1,83 1,39 2010 0,75 0,57 1,67 0,98 2011 0,90 1,30 1,65 1,39 2012 1,27 1,24 1,86 1,54 2013 1,21 1,09 2,78 1,09 2014 1,35 -0,05 1,50 0,80

Source: OECD DATA, This table shows yearly core inflation, which is headline inflation excluding food and energy prices, for Germany, Spain, the Netherlands and the euro area.

Having relatively high unemployment gap values in the first time frame could also explain the low recommended rates. Since the coefficient of this variable is negative, the gap should be either low or negative to produce this high Taylor rate. The striped

line in graph 3 represents the unemployment gap for Germany and together with table 2 this proves that the above is true and that from 2007 onwards these rates decline from 0,85% to minus 1,27%.

Table 2: Unemployment gaps in percentages Germany Spain Netherlands,

the Euro Area (19 members) 2001 0,71 -0,94 -1,75 n/a 2002 1,56 0,18 -0,93 n/a 2003 1,43 0,85 -0,02 0,63 2004 1,48 0,80 0,85 0,95 2005 2,64 -0,54 1,05 1,05 2006 2,12 -0,69 0,09 0,48 2007 0,85 -4,37 -0,60 -1,00 2008 0,26 -2,22 -0,96 -0,97 2009 0,57 1,26 -0,29 0,37 2010 0,09 1,54 0,72 0,60 2011 -0,93 1,72 0,68 0,46 2012 -1,22 4,03 1,47 1,36 2013 -1,20 4,73 2,86 1,75 2014 -1,27 2,93 2,90 1,54

Source: OECD DATA, This table shows the yearly unemployment gap, which is the difference between measured- and structural unemployment, for Germany, Spain, the Netherlands and the euro area.

A paper by Koske and Wörgötter (2010) contains an explanation for the low (high) optimal Taylor suggested interest rate for the first (second) period compared to the short-term interest rate set by the ECB. Germany was engaged in structural reforms in the first time frame: it relied on cutting its costs in order to stay competitive (Koske & Wörgötter, 2010). Its economy required a more accommodative instead of restrictive monetary policy, which was not the case until 2007 because the rate set by the ECB was too high. For the second time frame again the interest rate set by the ECB was not optimal according to the Taylor rule calculated rate for the German economy

experiencing a boom at the time, with differences even bigger than before. The German economy required a tighter monetary policy at the time as is visible from the graph.

These results of the first individual country Germany show that the optimal calculated Taylor rule rates are very different from the interest rate set by the ECB. Further results on the other individual countries must determine whether Germany

was an exception or that the ECB’s interest rate is indeed not optimal for individual countries according to the Taylor optimal rates.

iii. Spain

Investigating whether setting one interest rate for the euro area by the ECB is optimal for the individual chosen countries according to the Taylor rule leads to the

preliminary result that it is not for core country Germany. This section turns to peripheral country Spain in order to determine whether the same is the case.

Results of the calculated Taylor optimal rates are displayed with the ECB rate in graph 9.

Source: ECB, OECD DATA, OECD World Economic Outlook. This graph represents the Taylor rule’s target interest rate for Spain, along with the ECB’s short-term nominal interest rate. The vertical line marks the specified periods of stability from 2001 to 2006 and relative instability from 2007 to 2014.

The graph shows that the ECB’s target rate moved in the same direction as the simple Taylor rule version although the ECB rate was too low until 2009 and too high

afterwards. In comparison with Germany these high rates hint for high demand in Spain and low demand levels in Germany. These accommodative rates were almost three percent too low in the first time period for Spain, which means that borrowing was possible at rates that were set to low by the ECB. Inflation is then caused by increased product demand, which is boosted by these low interest rates as this

-6% -4% -2% 0% 2% 4% 6% 8% 10% 12% Pe rc ent age Year-Quarter

Graph 9: Spain

supports borrowing.

Luckily Spain at the time was having high growth rates, table 3, and no high structural unemployment. Later on, when the opposite was true and Spain was

suffering from low demand while the ECB was maintaining a too restrictive policy for Spain, it could not lower its interest rate or exchange rate to offset the low demand, which in turn led to higher structural unemployment.

Table 3: Real GDP Growth rates in percentages Germany Spain Netherlands Euro

Area (19 members) 2001 1,70 4,00 1,62 2,10 2002 0,01 2,88 -0,03 0,97 2003 -0,72 3,19 0,27 0,69 2004 1,18 3,17 1,86 2,25 2005 0,71 3,72 2,25 1,68 2006 3,71 4,17 3,82 3,26 2007 3,27 3,77 4,20 3,06 2008 1,05 1,12 2,08 0,49 2009 -5,64 -3,57 -3,30 -4,54 2010 4,09 0,01 1,07 2,05 2011 3,59 -0,62 1,66 1,66 2012 0,38 -2,09 -1,59 -0,83 2013 0,11 -1,23 -0,73 -0,36 2014 1,60 1,39 0,87 0,85

Source: Worldbank data. This table shows the yearly real GDP growth rate for Germany, Spain, the Netherlands and the euro area.

According to Feldstein (2011) the problems for Spain began with defaults on mortgages. These defaults would lead to bank troubles and government support, causing an increase in the debt of Spain (Feldstein, 2011). Furthermore, Bleich & Fendel (2012) argue that the real ‘IRPH’ rate, Spain’s mortgage interest rate deducted by expected inflation, decreased from above three percent in the beginning of 2001 to less than zero percent in 2005. They state that the ECB’s policy was too expansionary for Spain, resulting in cheap credit conditions for real estate, contributing to the Spanish housing boom. They state that a more restrictive policy with higher interest rates, used by the Banco de España before the Euro, could have avoided the trouble in Spain’s housing sector. Based on the conclusions described above, the statement Nechio made in her report (2011, p.4) that “one size does not fit all” is valid for

Spain.

Again, testing this simple version against its more comprehensive counterpart, it becomes clear from graph 10that both lines move close to each other although the more comprehensive recommended rates are higher for almost the entire first time period. This thus supports the view that the rate set by the ECB was too low and non optimal for Spain, as judged by both Taylor rule versions. Furthermore, the

recommended Taylor rates for both versions in the second time frame matches the ECB rate better from 2009 onwards.

Source: ECB, OECD DATA, OECD World Economic Outlook, Eurostat. This graph represents the simple- and comprehensive Taylor rule’s target interest rate for Spain, along with the ECB’s short-term nominal interest rate. The vertical line marks the specified periods of stability from 2001 to 2006 and relative instability from 2007 to 2014.

Concluding it is now clear that both theory and the Taylor rule show that the common rate set by the ECB is not optimal for Spain, where the question remains if it is for the Netherlands, or thus for no chosen individual country at all.

iv. The Netherlands

As becomes clear from the results of previous sections, although the common interest rate set by the ECB seems to match the Taylor optimal rate for the euro area, it does

-6% -4% -2% 0% 2% 4% 6% 8% 10% 12% Pe rc ent age Year-Quarter

Graph 10: Spain

not match the Taylor-optimal interest rates for Germany and Spain. Investigation will now be performed for the Netherlands to see whether the common rate is not optimal for every individual country.

The simple Taylor rule for the Netherlands has almost always been higher than the interest rate set by the ECB as is visible in graph 11. Lower ECB rates imply a too expansionary monetary policy than desirable for the Netherlands. Between the second quarters of 2005 and 2008 this was however clearly not the case as the Taylor optimal rate was lower than the rate set by the ECB.

Source: ECB, OECD DATA, OECD World Economic Outlook. This graph represents the Taylor rule’s target interest rate for Spain, along with the ECB’s short-term nominal interest rate. The vertical line marks the specified periods of stability from 2001 to 2006 and relative instability from 2007 to 2014.

During this period both inflation and the difference between measured and structural unemployment were low. Looking at the growth rate table 3 in the text, the Dutch growth rates appear to be relatively low which might be the reason the recommended rate is lower then the ECB’s rate for some quarters. As with Germany and Spain, the comprehensive model moves closely to the simple version for the Netherlands as well. The graph that displays this can be found in thegraph 12.

Most importantly it is clear that there is a huge gap between the rates from 2001 until 2003. The differences between the rates that would be optimal for the Netherlands according to both versions of the Taylor rule in this period compared to

0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% Pe rc ent age Year-Quarter

Graph 11: the Netherlands

Taylor simple ECB target

the rate set by the ECB illustrate again that this common rate is not optimal for individual country the Netherlands.

Source: ECB, OECD DATA, OECD World Economic Outlook, Eurostat. This graph represents the simple- and comprehensive Taylor rule’s target interest rate for the Netherlands, along with the ECB’s short-term nominal interest rate. The vertical line marks the specified periods of stability from 2001 to 2006 and relative instability from 2007 to 2014.

V. Conclusion

In this paper it has been analysedwhether the interest rate set by a common central bank matches the interest rate that would be optimal for individual countries predicted by the Taylor rule. A review of the existing literature on this subject showed that although using this simple rule optimal rate matches the rate set by the ECB for the euro area as a whole, cross-country differences would still be present and thus not optimal for individual countries: ‘one size does not fit all’ (Nechio, 2011, p. 4). The statement above is in line with the hypothesis of this paper thatthe

Taylor-recommended rates would align with the ECB’s rate for the euro are as a whole but that they would not for individual countries.

In order to examine whether the above is true, a simple rule has been used which calculates a recommended interest rate using only measured core inflation and the unemployment gap. Furthermore, the same has been performed using a more

0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% Pe rc ent age Year-Quarter

Graph 12: the Netherlands

Taylor simple Taylor comp. ECB target

comprehensive model with more variables in order to test the validity of the simple model. The sample period is from 2003-2014. While performing this analysis a clear distinction has been made between the period 2003-2007 and 2007-2014: periods of relative economic instability and stability because they include the financial crisis. This was done to see whether the simple Taylor rule version would perform different in times of relative instability.

First, the analysis for both periods has been performed for the euro area as a whole to see whether the first part of the literature review and hypothesis are true: that the rate set by the ECB matches the optimal rate as predicted by the Taylor rule for the euro area. Results have shown that the ECB short-term interest rate moved closely to the simple Taylor rule recommended rate in both time periods leading to the

conclusion that the ECB policy is in line with the Taylor predicted rate for the euro area as a whole. In addition the validity of the simple model has also been shown because the more comprehensive model matched the interest rate behaviour of the simple model.

Second, for the first time period of 2003-2007 the ECB target rate was too strict for Germany and too accommodative for both Spain and the Netherlands. These findings are in line with the second part of both the literature review and hypothesis that cross-country differences are present and that a common rate is not optimal for these selected individual countries according to the Taylor optimal rates.

Finally, the results show that the ECB target rate was too low for core countries Germany and the Netherlands in the second period of relative instability between 2007-2014 and too high for peripheral country Spain. Although it was too high for Spain it moved closer to its Taylor recommended rate than for Germany and the Netherlands. These results are also in line with the second part of the literature review and hypothesis that the common rate is indeed not optimal for the selected individual countries within the euro area.

Even though the hypothesis is true and it appears that setting a common interest rate is optimal for the euro area as a whole, this conclusion has to be taken with notable caution because setting a common rate for the euro area is definitely not optimal for individual countries and may lead to undesirable situations within

countries such as the housing bubble in Spain.

United States, were state differences are present. However, its labour mobility is much higher and allocations are made to smooth fiscal surpluses and deficits across states. Recreating these conditions for the euro area would call the need for a higher quality of governance and structural reforms to mobility across euro area countries. Even though this is one of the possible solutions to the interest rate-setting problem in a monetary union, it is highly unlikely countries would feel the need for structural reforms in times of financial instability. Luckily, being member of a monetary union has advantages as well: the costs caused by this non-optimal interest rate set by the ECB for individual countries could be offset by advantages such as reduction of transaction costs, increased transparency, trade creation and the ECB’s commitment to fight inflation. Although it became clear that one size does not fit all, the question if and how this size can be made universal without rigorous reforms can only be answered by time.

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VII. Appendix

Source: OECD DATA. This graph shows both core- and headline inflation for the euro area between 2001 and 2014 to outline the volatility differences between the two.

Source: OECD DATA. This graph represents the core inflation values for Germany, Spain, the Netherlands and the euro area from 2001 to 2014, subtracted by the 2% ECB target value. The vertical line marks the specified periods of stability from 2001 to 2006 and relative instability from 2007 to 2014.

-0,5% 0,0% 0,5% 1,0% 1,5% 2,0% 2,5% 3,0% 3,5% 4,0% P er ce nage Year-Quarter

Graph 13 : Euro Area Inflation

Core Headline -2,5% -2,0% -1,5% -1,0% -0,5% 0,0% 0,5% 1,0% 1,5% 2,0% 2,5% Pe rc ent age Year-Quarter

Graph 14: Inflation deviation from ECB target

Germany Spain

the Netherlands Euro area

Taylor optimal rates (in percentages, continued on next page)

Germany Spain the

Netherlands

Euro area

Year-Q ECB Rate Ts Tc Ts Tc Ts Tc Ts Tc

2001-01 4,75 1,47 2,37 7,36 7,87 7,77 7,22 n/a n/a 2001-02 4,58 2,16 3,11 7,46 7,89 8,26 7,46 n/a n/a 2001-03 4,25 1,83 2,94 7,15 7,49 8,48 7,67 n/a n/a 2001-04 3,42 1,81 3,19 6,88 7,41 8,65 7,95 n/a n/a 2002-01 3,25 2,62 3,54 4,65 5,60 7,66 6,42 n/a n/a 2002-02 3,25 2,07 3,23 6,26 7,42 7,55 6,38 n/a n/a 2002-03 3,25 1,64 3,12 3,30 4,83 6,87 6,00 n/a n/a 2002-04 3,08 0,87 2,66 6,09 7,51 6,05 5,28 n/a n/a 2003-01 2,67 1,28 1,62 4,63 6,36 5,17 3,91 3,19 3,70 2003-02 2,33 0,84 1,38 4,88 6,50 4,18 3,25 3,19 3,70 2003-03 2,00 0,92 1,50 4,45 6,19 3,92 3,14 2,94 3,45 2003-04 2,00 0,99 1,53 4,05 5,64 3,54 2,99 2,92 3,43 2004-01 2,00 1,53 1,79 3,42 5,05 2,67 2,64 2,72 3,70 2004-02 2,00 2,46 2,74 3,59 5,32 2,57 2,87 2,85 3,83 2004-03 2,00 2,10 2,57 3,92 5,44 2,70 2,73 2,88 3,86 2004-04 2,00 2,33 2,90 4,45 5,58 2,46 2,79 2,87 3,85 2005-01 2,00 0,85 2,01 4,67 5,70 2,20 2,95 2,27 3,46 2005-02 2,00 -0,54 1,11 4,84 5,45 1,76 2,58 2,12 3,31 2005-03 2,00 -0,30 1,35 5,63 5,44 1,73 2,33 1,89 3,08 2005-04 2,08 -0,13 1,33 5,91 5,77 1,92 2,36 1,99 3,18 2006-01 2,33 -0,16 2,63 5,51 6,56 1,13 2,10 2,42 3,92 2006-02 2,58 0,48 2,79 5,86 6,71 1,70 2,40 2,68 4,19 2006-03 2,92 0,64 2,60 6,10 6,74 2,01 2,57 2,68 4,19 2006-04 3,33 0,90 2,82 5,78 6,36 1,98 2,41 2,83 4,34 2007-01 3,58 2,11 4,50 9,38 6,93 3,42 4,93 4,74 5,49 2007-02 3,83 3,10 5,09 9,38 6,79 4,14 5,34 4,88 5,63 2007-03 4,00 3,42 5,26 8,96 6,63 3,91 4,93 4,83 5,58 2007-04 4,00 3,55 5,20 8,43 6,43 3,70 4,55 4,86 5,61 2008-01 4,00 2,92 4,28 8,60 5,98 4,27 5,26 4,77 4,96 2008-02 4,00 2,33 3,70 7,32 5,84 4,19 5,15 4,61 4,80 2008-03 4,25 3,14 3,98 6,65 6,33 4,76 5,53 4,77 4,96 2008-04 3,17 2,99 3,77 4,33 6,26 5,30 6,10 4,85 5,04 2009-01 1,83 2,42 0,61 3,31 2,72 4,46 3,03 3,05 1,92 2009-02 1,08 2,43 0,83 1,50 2,02 4,23 3,18 3,01 1,88 2009-03 1,00 2,02 0,59 -0,10 0,83 3,96 3,28 2,55 1,43 2009-04 1,00 2,33 0,46 -0,93 0,51 3,49 3,04 2,28 1,16 2010-01 1,00 1,71 1,39 0,14 0,16 3,25 3,63 1,71 1,36 2010-02 1,00 2,00 1,24 -0,50 0,20 3,20 3,67 1,77 1,42

2010-04 1,00 2,22 1,07 0,92 1,85 2,46 2,77 2,03 1,68 2011-01 1,00 2,72 2,32 2,20 1,99 2,66 2,84 2,19 2,11 2011-02 1,25 3,17 2,47 2,28 2,33 2,66 2,87 2,84 2,76 2011-03 1,50 3,42 2,58 0,69 1,76 3,14 3,63 2,54 2,46 2011-04 1,25 3,81 2,66 -0,23 1,67 2,76 3,60 2,94 2,85 2012-01 1,00 3,93 2,81 -0,49 0,38 2,29 2,02 1,96 2,15 2012-02 1,00 4,05 2,86 -1,69 0,18 1,98 2,02 1,99 2,18 2012-03 0,75 4,12 2,89 -1,59 1,03 2,68 2,90 2,00 2,19 2012-04 0,75 4,43 3,18 -0,90 2,26 2,32 2,93 1,83 2,02 2013-01 0,75 3,79 2,41 -0,96 1,24 3,11 3,06 1,30 1,36 2013-02 0,58 3,81 2,36 -1,28 0,90 2,56 3,20 0,91 0,97 2013-03 0,50 4,25 2,70 -2,42 -0,28 2,38 3,52 0,85 0,91 2013-04 0,33 4,19 2,61 -3,71 -2,00 1,20 2,27 0,50 0,56 2014-01 0,25 4,44 3,28 -3,00 -1,77 0,68 1,43 0,72 0,70 2014-02 0,22 4,42 3,19 -2,12 -1,49 0,05 0,87 0,68 0,66 2014-03 0,12 4,26 3,00 -1,68 -1,52 0,30 0,89 0,70 0,68 2014-04 0,05 4,09 2,83 -1,21 -1,52 0,41 0,94 0,53 0,51

Source: ECB, OECD DATA, OECD World Economic Outlook, Eurostat. This table shows the Taylor

recommended rates for Germany, Spain, the Netherlands and the euro area. Rates have been calculated by using equations (1) and (2). Symbol explanation: Year-Q = Year-Quarter, Ts = simple version recommendation, Tc = comprehensive version recommendation. Data for the euro area unavailable until 2003.