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Did Greenspan Open Pandora's Box? Testing the Taylor Hypothesis and Beyond

Palma, Nuno (2013): Did Greenspan Open Pandora's Box? Testing the Taylor Hypothesis and Beyond.

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Abstract

The Taylor hypothesis is the conjecture that the 2007-2009 financial crisis and the 2008-present downturn have been caused by loose monetary policy during 2002-2006. According to the Taylor hypothesis the Fed deviated from well-know rules of monetary policy-making over this period, and this deviation caused an inefficient boom and subsequent bust. I use a well know economic model of the US aggregate economy (Christiano, Eichenbaum and Evans 2005) to test this hypothesis. I interpret shocks as deviations from Taylor-type rules. I conclude that the Taylor hypothesis for the Taylor rule fails to reproduce observed fluctuations in the data. Output increases only 0.3% at maximum which occurs at 2004:Q2. In the data, the output gap was at it's maximum in 2006:Q3. However, the Taylor hypothesis modified to incorporate persistence in the policy rule can partly explain the boom of the economy after 2001.

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