How Effective is the Taylor rule? : Some Insights from the Time-Frequency Domain

When the central bank sets monetary policy according to a conventional or modified Taylor rule (which is known as the Taylor Principle), does this deliver the best outcome for the macroeconomy as a whole? This question is addressed by extending the wavelet-based control (WBC) model of Crowley and Hudgins (2015) to evaluate macroeconomic performance when the central bank sets interest rates based on a conventional or modified Taylor rule (TR). We compare the simulated performance of jointly optimal fiscal and monetary policy under an unrestricted baseline model with performance under the TR. We simulate the model under relatively small and large weighting of the output gap in the TR specification, and for both low and high inflation environments. The results show that the macroeconomic outcome depends on whether the conventional or modified Taylor rule is used, and whether the central bank is operating in a low or high inflation environment.