THE PERFORMANCE OF THE TAYLOR RULE IN EMERGING ECONOMIES

Since 1990s, many emerging economies (EMEs) have decided on inflation targeting as an effort to reduce high inflation, establish a stable economy, and recover economic prosperity. Compared with the vast literature for advanced economies, the application of the Taylor rule has just increased recently in EMEs. Furthermore, there are limited number of studies investigating how Taylor rule can approximate the process of interest rate setting in EMEs. Considering the post-crisis period, studies investigating the performance of the Taylor rule in capturing the decision of monetary authorities in EMEs are scant. The objective of this paper is to examine some crucial issues regarding how the interest rate instrument is set in EMEs. First, how can the setting of interest rate instrument be represented by a Taylor rule? Second, is the response of interest rate to inflation and output consistent with the Taylor principle? Third, are there any differences in the policy of interest rate before and after crisis? We apply the generalized method of moments (GMM) to estimate different specifications of Taylor rule because of the problem of endogeneity. The use of realized inflation as a proxy for expected inflation introduces the forecast error into the disturbance term, leading to the correlation between expected inflation and disturbance terms. Moreover, we apply Bartlett kernel procedure to the standard errors so that they are robust to the presence of heteroskedasticity and serial correlation. The choice of lagged instruments satisfies the overidentification test and the weak instrument test. The paper found that the Taylor rule is a good approximation of the process of interest rate setting in EMEs. The interest rate positively responds to both inflation and output but the reaction does not follow the Taylor principle. Furthermore, the rule indicates weaker response to inflation and stronger response to output after the crisis. In addition, the implication of the exchange rate shows a reduction during the post-crisis period.