Lucjan T. Orlowski, Ph.D., John F. Welch College of Business, Sacred Heart University, 5151 Park Avenue, Fairfield, CT 06825
Searching for an accurate specification of the monetary policy Taylor rule is the primary goal of this paper. The Taylor rules in various forms are examined for several new EU Member States that are actively pursuing convergence to the euro. The tested instrument rules are all based on open economy parametrization, i.e., they contain the path of exchange rate in addition to forward-looking inflation and output gap variables. Inflation as a dependent variable is treated as a forwarded differential between the domestic and the eurozone headline inflation rates. The model is an extension of the originally proposed by Orlowski (2005) forward-looking differential-based rule as an implicit mechanism of the macroeconomic policy coordination on the convergence path. The empirical tests assume several specifications of the output gap variable, including output deviation from the linear trend as in the original model of Taylor (Carnegie RS, 1993), deviation of log of industrial production from the quadratic trend as in Clarida, Gertler, Gali (EER,1998 and QJE 2000), a combination of the current minus five-year moving average unemployment rate with the difference between the actual and the trend GDP growth rate as in Koenig (FRB Dallas, 2004), as well as deviation of log of industrial production from the Hodrick-Prescott-filtered trend. Interest rate smoothing is applied as well. Preliminary tests show usefulness of elaborate instrument rules utilizing the forward-looking inflation differential for guiding interest rate convergence to the predicted path of the eurozone interest rates.