Different Between Adaptive and Rational Expectation

Working Paper No. 00-01-01

Are Policy Rules Better than the Discretionary System in Taiwan?
James P. Cover
C. James Hueng and Ruey Yau

Are Policy Rules Better than the Discretionary System in Taiwan?

James Peery Cover Department of Economics, Finance, and Legal Studies University of Alabama Phone: [phone] Fax: [phone] Email: [e-mail] C. James Hueng Department of Economics, Finance, and Legal Studies University of Alabama Phone: [phone] Fax: [phone] Email: [e-mail] and Ruey Yau Department of Economics Fu-Jen Catholic University Taiwan Phone: [phone] Fax: [phone] Email: [e-mail]

Correspondence to:

C. James Hueng Department of Economics, Finance, and Legal Studies University of Alabama, Box 870224 Tuscaloosa, AL 35487 Phone: [phone] Fax: [phone] Email: [e-mail]

Are Policy Rules Better than the Discretionary System in Taiwan?

ABSTRACT This paper investigates whether the central bank of Taiwan would have had a more successful monetary policy during the period 1971:1 to 1997:4 if it had followed an optimal rule rather than the discretionary policies that were actually employed. The paper examines the use of two different instruments—the discount rate and the monetary base—with several different targets — growth of nominal output, inflation, the exchange rate, and the money growth. The results show that most of the rules considered would not have significantly improved the performance of the Taiwanese economy. The only rule that is clearly advantageous is one that targets inflation while using the interest rate instrument.

Keywords: monetary policy rule, small open economy, dynamic programming JEL classification: E52, F41

1. Introduction How well has the Central Bank of Taiwan implemented monetary policy during the past three decades? With the exception of two inflationary episodes during periods of oil-price shocks (1973-1974 and 1979-1981), as far as inflation