Monetary Policy in Europe: Evidence from Time-Varying Taylor Rules

We estimate monetary policy reaction functions for France, Germany, Italy, the United Kingdom, and the United States using a Markov-switching model that incorporates switching in the monetary policy regime as well as an independent switching process for shifts in the state of the economy. Results indicate that over time all central banks have assigned changing weights to inflation and the output gap. Regimes can be classified as ``dovish" with a high weight on output and a low weight on inflation, and ``hawkish" with a high weight on inflation and a low one on output. For France and Italy, the German interest rate had an influence on domestic monetary policy especially at the beginning of the 1980s after the inception of the European Monetary System (EMS). Switching in the residual variance of the monetary rule accounts for heteroscedasticity and turns out to be important for the fit of the model. Robustness of the results is checked by considering alternative specifications of expected inflation and the output gap. In general, results are robust to these changes.