A researcher estimates by Ordinary Least Squares the following monetary policy rule for the UK using quarterly data over the 1963-2020 period (standard errors are given in parentheses):

it =	constant	+1.5(1-dt)*πt	+2.1dtπt	+0.1yt	-0.5f_stresst
(0.50)	(0.90)	(0.01)	(0.10)

Adjusted R²=0.81.

The variable definitions are:

i_t: policy interest rate (%).

π_t: Consumer Price Index (CPI) inflation (%).

y_t: deviation of output from its long-run level (%) as a proxy of excess demand. Positive (negative) y_t values imply that output is above (below) its long-run level.

f_stress_t: A measure of financial stress in the UK. This pools information from the volatility of the exchange rate, the volatility of the equity market, the volatility of the bond market and the risk premium that investors demand to hold UK corporate bonds rather than the less risky UK government bonds. An increase in the variable indicates additional financial stress.

d_t: A dummy variable such that d_t=0 when CPI inflation is between 1% and 3% and d_t=1 when CPI inflation is lower than 1% or higher than 3%.

Q: An analyst argues that the monetary policy rule discussed at above model is misspecified for two reasons. First, policy rates in the UK respond to international monetary policy conditions. Second, UK policymakers might be willing to act more aggressively to a big increase in financial stress. How would you modify the monetary policy rule to address the analyst’s concerns? 

Answer rating: 100% (QA)

ANS WER The monetary policy rule could be modified to include a measure of international monetary po... View the full answer