European Economy. Economic Papers. Germany's growth performance in the 1990's

2.1.2 Measuring monetary policy
An analysis could be based on two monetary policy indicators: (1) The Taylor rule, which
makes the short-term interest rate dependent on current cyclical and inflation developments. (2)
Figure 2.3:
German Yield Spread and Output Gap
- 2
- 1
0
1
2
3
4
5
6
1 9 8 8
1 9 9 0
1 9 9 2
1 9 9 4
1 9 9 6
1 9 9 8
2 0 0 0
O u tp u t g a p D
Y ie ld s p r e a d D

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Figure 2.5:
Taylor Rates and Actual Interest Rates
(Short-term interest rates in %, actual and implied by the
Taylor rule)
Germany
1
2
3
4
5
6
7
Jan-96
Jan-97
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
1
2
3
4
5
6
7
Euro area
1
2
3
4
5
6
7
Jan-96
Jan-97
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
1
2
3
4
5
6
7
The Monetary Conditions Index (MCI), which combines changes in the real short-term interest
rate and in the effective exchange rate in one variable.
Taylor rates assume that
a central bank sets its
policy interest rates
depending on the current
situation with regard to
the business cycle and
inflation. The cyclical
situation is assessed
using the output gap
measure while inflation
is measured by the
difference between
targeted and observed
inflation. Thus an
excessive increase in
prices and an over-
utilisation of productive
capacities would trigger
an increase in short-term
interest rates.
Calculations of Taylor
rates for Germany have
produced different
results. While the
academic literature
provided evidence that
the approach can explain
German monetary
policy, the Bundesbank
itself published a less
positive assessment in
retrospect.
15
Calculations by the
Commission services
indicate that the actual
interest rate was within
the band derived from
calculations under
alternative assumptions
up to late 1998 (Figure 2.5). As the Stage III of EMU was approaching the actual interest rate
exceeded the Taylor rate, i.e. the interest rate chosen with respect to the whole Euro-area was
too high by German needs. However, in early 2000 the acceleration in economic growth in the
Euro-area triggered an interest rate that was above the one that would have been appropriate
according to Taylor-rate estimates, while it was mainly appropriate for the Euro-area as a whole
in early 2000 (see lower part in Figure 2.5). The decline in interest rates in 2001 changed the
assessment again as the interest rate appears now almost appropriate for Germany, but too low
for the Euro-area as a whole.
15
See Clarida, R. and M. Gertler 1996.
Actual
Actual

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