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Board of Governors of the Federal Reserve System

International Finance Discussion Papers

Number 705

August 2001

AN EMPIRICAL COMPARISON OF BUNDESBANK AND ECB MONETARY POLICY RULES

Jon Faust, John H. Rogers, and Jonathan H. Wright

NOTE: International Finance Discussion Papers are preliminary materials circulated to stimulate
discussion and critical comment. References in publications to International Finance Discussion Papers
(other than an acknowledgment that the writer has had access to unpublished material) should be cleared
with the author or authors. Recent IFDPs are available on the Web at www.federalreserve.gov/pubs/ifdp/.
AN EMPIRICAL COMPARISON OF BUNDESBANK AND ECB MONETARY POLICY RULES

Jon Faust, John H. Rogers, and Jonathan H. Wright*

Abstract: We estimate a monetary policy reaction function for the Bundesbank and use it as a benchmark to
assess the monetary policy of the ECB since the launch of the euro in January 1999. We find that euro interest
rates are low relative to this benchmark. We consider several possible reasons for this, including the divergence
between core and headline inflation, mis-measurement of the output gap, inflation having turned out to be higher
than could have been foreseen by the ECB and the possibility that the ECB is focusing only on macroeconomic
conditions in a subset of member countries. We argue that none of these potential explanations alone can
account for the difference between recent interest rates and our estimated Bundesbank benchmark. Our results
suggest that the reaction function of the ECB features a high weight on the output gap relative to the weight on
inflation, compared to the Bundesbank.

Keywords: Taylor Rule; Monetary Policy; European Central Bank; Bundesbank; Inflation.

*
Division of International Finance, Board of Governors of the Federal Reserve System. We are grateful to Joe
Gagnon, Mark Gertler, Dale Henderson and Linda Kole for helpful comments. The views in this paper are
solely the responsibility of the authors and should not be interpreted as reflecting the views of the Board of
Governors of the Federal Reserve System or of any person associated with the Federal Reserve System.
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4<
Table 1: Bundesbank Estimated Reaction Function

α 2.58
(0.85)
β 1.31
(0.35)
γ 0.18
(0.16)
ρ 0.91
(0.03)

Table 2: Inflation forecast that equates actual and fitted target interest rates

1999:01 0.38 2000:02 0.12
1999:02 0.63 2000:03 0.32
1999:03 0.37 2000:04 0.50
1999:04 0.23 2000:05 0.44
1999:05 0.14 2000:06 1.00
1999:06 -0.01 2000:07 0.88
1999:07 -0.07 2000:08 0.71
1999:08 -0.23 2000:09 1.06
1999:09 -0.24 2000:10 1.25
1999:10 -0.27 2000:11 1.14
1999:11 -0.01 2000:12 0.75
1999:12 0.20 2001:01 1.02
2000:01 0.21 2001:02 1.09

20
Table 3: Fitted target interest rates using individual country inflation and output gap data

France FRG Italy Spain Belgium NLD Austria Finland Ireland Portugal EuroWide Actual
99:01 4.85 4.95 5.34 6.73 3.38 4.61 3.79 6.07 9.36 5.51 5.18 3.14
99:02 4.57 4.95 5.29 6.46 4.31 4.59 4.66 6.44 9.32 5.13 4.94 3.11
99:03 4.81 4.94 5.78 6.57 5.39 4.71 4.88 6.66 8.79 4.98 5.22 2.93
99:04 4.32 4.39 5.30 6.72 5.18 4.58 4.64 6.17 9.06 5.65 4.90 2.68
99:05 4.74 4.31 5.18 6.83 5.38 5.18 4.62 5.72 9.08 6.25 4.88 2.55
99:06 5.10 5.18 5.87 7.38 6.49 5.63 5.81 6.30 9.65 6.85 5.73 2.57
99:07 5.38 5.24 5.93 7.80 4.93 6.48 5.10 6.06 10.61 7.39 5.75 2.51
99:08 5.34 5.25 6.00 7.52 7.26 5.56 5.13 5.72 10.06 7.99 5.74 2.43
99:09 5.93 6.10 5.91 7.88 8.01 6.19 5.94 6.68 10.39 7.41 6.37 2.42
99:10 5.78 5.97 6.18 8.17 8.02 6.66 5.84 6.16 11.01 7.87 6.36 2.49
99:11 6.06 6.25 6.54 8.33 8.04 6.38 6.98 6.16 10.49 8.08 6.69 2.92
99:12 5.17 5.86 6.30 8.34 6.65 6.48 5.61 6.84 9.35 7.95 6.14 3.03
00:01 4.59 5.62 6.08 7.98 6.04 7.87 5.49 6.42 5.45 8.53 5.87 3.03
00:02 4.79 6.30 6.36 8.56 6.65 9.01 5.75 6.10 6.68 8.64 6.47 3.27
Discrep 2.31 2.59 3.07 4.73 3.33 3.20 2.51 3.46 6.44 4.23 2.94
Note: Discrep is the average discrepancy between the target shown in the column and the actual rate that prevailed (i.e., the column
average minus the average of the final column).

21
Figure 1: Output Gaps for Germany and the Euro Area
15
Germany
Euro−area

10

5

0

−5

−10

−15
1985 1990 1995 2000
Figure 2: Forward looking Taylor rule
14

Actual Interest Rate
Fitted Target Rate
12

10

8

6

4

2

0
1985 1990 1995 2000