Nationalekonomiska Institutionen

Was the Euro interest rate too low for Ireland?

- A time series analysis of the pre-EMU period in light
of the Taylor Rule

Författare: Sharkah Francis & Pawela Oliver

Handledare: Erixon Lennart
Kurs: EC6901 Kandidatuppsats i nationalekonomi
Termin: VT2010

1
 Abstract

This paper focuses on the application of the Taylor Rule to estimate a counter-
option nominal interest rate suitable for Ireland during the post EMU era. We used
an Ordinary Least Square regression method to estimate the Taylor rule
coefficients, from which we calculate a Taylor type rule interest rate based on the
economic indicators in the post EMU era. The reason behind this study is to
assess the probable benefits Ireland gained or lost upon joining the EMU. To do
so the Taylor Rule is set as a counter-option to the European Central Bank’s
interest rate to show another outcome as rendered by the theoretical rule. We
address the question of loosing monetary policy as a counter-cyclical tool in the
economy as well as the constituency of the European Optimum Currency Area.
We also analyse the reliability of our induced Taylor rule. We found that the
interest rate set by the ECB are not in response to the economic realities in
Ireland.

Acknowledgement

We thank our supervisor associate professor Lennart Erixon for his guidance and
engagement during the entire project.

Keywords: Monetary policy, EMU, Optimum Currency Area, Taylor rule.

2
Contents

1. Introduction……………………………………………………………………4
1.1 Background of the study…………………………………………………….4
1.2 Objective of the study……………………………………………………….6

2. Theoretical background……………………………………………………….7
2.1 Theory of Optimal Currency Area…………………………………………..7
2.2 The Taylor Rule……………………………………………………………..9

3. Earlier studies………………………………………………………………...12

4. Empirical Section……………………………………………………………13
4.1 The Regression Model……………………………………………………..13
4.2 Regression Technique and Problems………………………………………14
4.3 Statistical sources and limitations………………………………………….16
4.4 Choice of time period………………………………………………………18

5. Regression result and analysis………………………………………………19

6. Conclusion…………………………………………………………………….21

References……………………………………………………………………….23

Appendix………………………………………………………………………...25

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1. Introduction

1.1 Background of the study

Ireland was once referred to as the “Celtic Tiger”, the best performing economy in
the euro zone. It was hailed across the globe as a model for other countries to
follow, prompting policy makers and investors from around the globe to flock to
Ireland to learn about the secrets behind its economic performance. However this
success was short lived, as Ireland became the euro zone’s first member country to
officially slide into a recession during the present global financial crisis. Ireland
has regulation encouraging foreign direct investment, whereby the economic
growth experienced from 1989, which created the basis for the housing market
growth. A mix of high levels of employment, higher incomes, immigration and
even features in the housing tax system created a greater demand for housing in
Ireland. Inevitably Ireland’s entry into the EMU added more salt into its injuries,
when the ECB led nominal and real short-term interest rates fell sharply.

The housing market as an interest rate sensitive sector of the economy contributed
to the growth trend experienced in Ireland between 2000 and 2006, which in turn
potentially created conditions that put the nation into its present financial
situation. The collapse of the construction industry and the export sector has
created a drop in income and property sales tax revenue, leaving a big hole in the
country’s public finances that has resulted in an increase in government
borrowing. Although the Irish government is not in the same position as it once
was to influence the low interest rates that prevails in the euro zone, it could have
provided fiscal stimulus to avoid the problem, as was done in Finland for instance,
but instead it had to increase taxes and cut on public spending – measures that are
further aggravating the financial problem.

Ireland being an export-dependent economy implies that the economic standings

of its trading partners also affect its potential of getting out of the financial crisis
sooner. The US and the UK are two of Irelands largest trading partners, hence a
mixture of deepening recessions in these countries, with a sharp rise in the value
of the euro against the pound sterling and dollar further worsens the financial

4
problem. Ireland’s membership in the EMU therefore means that the necessary
real exchange rate adjustment can only be brought about through changes in
domestic prices – including wages. Whilst the leading majority of the Unions
members were showing reports of collapse, the Irish economy held relatively well
against the storm. Assuming that the ECB follows through on its policy to
maintain the union’s price stability goal calculated mainly on the inflation rate,
M3 expansion, and GDP growth in given member country’s we can easily
establish that the ECB will allow a lower interest rate than needed for Ireland.

When the euro was introduced in 1999, the question most economists around the
globe posed was: how would a single macroeconomic policy framework satisfy
the requirements of such a diverse group of economies with no federal budget
system as in the case of the USA? Fiscal policies are still at the discretion of
national governments, but even so there are rigid conditions under which these
policies should be used. Individual governments within the EMU could no longer
influence exchange rates, and more importantly, control over their individual
monetary policies was lost. When Ireland joined the EMU in 1999 it completely
lost sovereignty over its monetary policy and in the process lowering its nominal
interest rate from 6 to 3 percent. It effectively lost control over the boom it was
already experiencing and since then inflation in consumer prices has risen well
above the EU average. One of the benefits Ireland was getting rid of exchange
rates fluctuations with other EMU countries, but the consequences have been
worsened competitiveness for its export industry, and an eventual cost crisis –
chiefly in the housing sector. While monetary policy is no longer available as an
instrument of domestic policy, fiscal policy is the only tool that could be used to
stimulate the economy, but yet under stringent conditions.

The lessons of the first years of membership is that the focus of fiscal policy
within Ireland needs to change, and that the EU institutions also need to focus
more clearly on the needs of the Euro area rather than on those of individual
regional economies. The simplest way to estimate a counter-option to the ECB
rate is by applying the Taylor rule.

5
1.2 Objective of the study

We will seek to estimate a monetary policy for Ireland in the framework of the
Taylor rule during 1990-2009, which specifies that the real policy rate reacts to
two crucial variables: deviations of inflation from its targeted level and deviations
of real GDP from its long-run potential. The rule sets the nominal policy rate
equal to the rate of inflation plus an equilibrium real interest rate and the weighted
average of these deviations. It suggests that, if inflation is equal to the inflation
target level, and that the unemployment rate is equal to the equilibrium rate of
unemployment, then the central bank should set the nominal interest rate equal to
its target level.

Our main question is: At what level would the nominal interest rate stand if
Ireland weren’t in the EMU? The reason behind this research is primarily the
concern of a sovereign nation’s own good. The main benefits of joining the union
are located within a broad spectrum of economical endowments. If these
endowments are granted by surrendering pieces of a nation’s independence, at
least in an economical sense, then primarily, the arguments, benefits, and
endowments for joining must be of such gargantuan stature to offset the losses.
Considering that these principals have been surrendered then surely the grants
must be given. The empirical evidence suggests otherwise and the position of the
Irish economy might be juxtaposed to that of the rest of the Union.

We will apply the Ordinary least Square (OLS) regression method on a time series
data collected from databases of the Central Statistical Office (CSO) in Ireland
and Eurostat, in order to estimate the reaction coefficients for a Taylor type rule
for Ireland for the period 1990-2000. To estimate these coefficients we conduct
two separate regressions; the first on a quarterly time series data from the first
quarter of 1990 to the last quarter of 1995, and the second on a quarterly time
series data from the first quarter of 1997 and the last quarter of 2000. We will then
extract the coefficients from these two separate regressions together with averages
of the real interest rate, inflation rate and GDP gap between the periods of 1990-
2009 and from which calculate an estimate of a nominal interest rate for Ireland.

6
This paper is structure as follows. In section 2, we will present the theoretical
background on the theory of optimal currency area and the Taylor rule. Section 3
will summarize earlier studies done on Ireland’s monetary policy treated under the
framework of the Taylor rule. Section 4 is the empirical section. In section 5, we
will present our results, and analysis. Finally, in section 6 some concluding
remarks.

2. Theoretical background

2.1 Theory of Optimal Currency Area

The debates in economics over the desirability of a currency union in Europe

began with Robert Mundell's 1961 introduction of the concept of an optimal
currency area, with the core properties of trade integration, factor mobility, fiscal
federalism, cyclical convergence, and wage- and price flexibility. Proponents of
the EMU argue that the project has been successful in terms of reduced trade
barriers within Europe. Mundell (1961) argued that a monetary union should be
no larger than the area over which similar business cycles typically prevailed or
over which labour is easily mobile. A currency union larger than that will allow
localized recessions and high levels of unemployment, about which monetary
policy can do nothing. Taking into account the contrast that existed between the
expansionary boom in the Netherlands and Ireland during the early years of their
memberships, most studies suggest that the business-cycle conditions differ
amongst EMU member states from the unset, and that the no bailout clause in the
Maastricht treaty could have even made the present situations of localized
recessions worse for most of these countries. The differences in labour unions,
languages and cultures also remain a major barrier to labour mobility.

The United States, appears to meets Mundell’s criterion for an optimal currency
area as compared to Europe. One of several reasons prompting quick adjustments
to asymmetrical shocks within the United States is the adoption of a cross-regional
fiscal transfer policy. Charles Goodhart (1995), argues that in the absence of
flexible markets – particularly labour markets – the effects of asymmetrical
shocks on inter-state inequalities of income can be mitigated only by

7
re-distributional federal taxation system, and that their effects on cyclical changes
in incomes and employment can be lessened by the stabilising properties of fiscal
measures.1 During the late 80’s, the United States as a whole was in a period of
considerable prosperity and appeared to need a restrictive monetary policy. The
Dallas Federal Reserve District, however, was in a recession, caused by a sharp
decline in the prices of oil and natural gas, and would have benefited from
relatively easy money. The policy of the Federal Reserve Board was determined
by the apparent needs of eleven districts rather than one, meaning that Texas and
neighbouring states had to survive a monetary policy that was inappropriate for
their needs. Within the United States, the federal government absorbs about 35
percent of the costs of a localized recession through reduced tax receipts and
increased transfer payments. There are no such fiscal arrangements in Europe,
which means that a localized recession in Ireland will not be partially absorbed by
the other members of the European Union through reduced tax payments and
increased transfer payments. The cost of the present recession in Ireland is hence
carried entirely by the Irish government without any help from Brussels, making
its localized recession considerably more painful.

Nils Gottfries (2003) found that to have the same interest rate within the EMU and
the same exchange rate against other countries out of the EMU could be
problematic if developments in a member country differ greatly from others
within the union as a whole and that the problem of asymmetrical shocks would
be inevitable, just as in the case of Ireland and Germany during their first year of
membership in the EMU. He also agued that the ECB succeeded in establishing a
common nominal interest rate but failed to establish a common and stable
inflation within the union. With this background, having a common nominal
interest rate within the euro zone, would further strengthen asymmetrical shocks
within the union.

1
http://www.prospect-magazine.co.uk/article_details.php?id=5195

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2.2 The Taylor Rule

The interest rate targeting scheme that has become widely known as the Taylor
rule was first presented by John Taylor (1993) for illustrative purposes. By linking
interest rate decisions directly to inflation and economic activities, Taylor offered
a convenient tool for studying monetary policy while abstracting from a detailed
analysis of the demand and supply of money. The Taylor rule has become a
widely used tool in macroeconomic policy analysis, partly due to its simplicity
and partly because it captures some key macroeconomic variables.

He argued that since central banks affect spending through the interest rate, a
central bank should then think directly in terms of the choice of an interest rate
rather than in terms of the rate of money growth as proposed by Milton
Friedman.2 While the optimal nature of this rule has attracted increased attention
in series of economic journals and empirical studies, no country in the west seems
to have taken any definite step in implementing the Taylor rule formally.
Nonetheless the rule has proven to predict the behaviour of monetary policy quite
well especially in the United States, and Germany over the past 15 years. Since
Taylor’s initial formulation of the rule in 1993, economists around the world have
modified it in different ways, to analyze reaction functions for numerous central
banks in the OECD countries.

The Taylor rule stipulates the level of policy rates to be a function of the output
gap, divergences of actual rates of inflation from a target, and the equilibrium
level of interest rates. In other words the Taylor rule uses inflation and gross
domestic product to predict changes in the nominal interest rate. It is typically
expressed as:

it  r *   t  1 ( t   * )   2 y t (1)

2
The Milton Friedman’s k-percent rule (Friedman, 1960), draws on the equation of exchange
expressed in growth rate: m  v    q , where   p is the rate of inflation and
p, m, v and q are respectively, price level, money stock, money velocity and real output. It
proposes that central banks should select a constant growth of money, k, to correspond to the sum
of a desired inflation target,  , and the economy’s potential growth rate, q , and adjusting for
* *

any secular trend in the velocity of money, v * .

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Where i t is the nominal interest rate at time t, r * is the equilibrium real interest

rate,  t is the average inflation for the previous four quarters (including the

current one) at time t, and is usually measured by core CPI, ( t   * ) is the

deviation of the inflation rate from its target level  * , and y t  (Yt  Yt * ) / Yt is

the deviation of output Yt from its full-employment level, Yt * . The four

parameters, r * ,  * , 1 and  2 for the United States were taken by Taylor as,
respectively, 2 percent, 2 percent, 0.5 and 0.5, under the assumption that the
central bank has the information on current output and inflation. 1 and  2
indicate the sensitivity of the nominal interest rate changes to each of the two gaps
– inflation and output respectively.

Taylor predicts that central banks will increase interest rates when inflation rises
above the target level or output moves above its full-employment level, and vice
versa. The nominal interest rate component, r *   t , defines the level at which the
nominal interest rate would settle were inflation stable at its target rate and output
maintaining its full-employment level. The inflation gap component, 1 ( t   * ) ,
indicates that when inflation rises above its target level, the central bank raises the
nominal interest rate by a multiple of the difference – an action that slows money
growth, which in turn reduces future inflation. The output gap component,
2 (Yt  Yt* ) , indicates that when output falls short of its full-employment
potential, the central bank lowers the nominal interest rate – an action that
stimulates economic growth, raising output towards its potential.

Taylor found that his rule neatly described the US Federal Reserve's decision-
making process, and it is now widely used by forecasters to estimate the desired
level for policy rates. The most attractive quality of the Taylor rule is that it is a
simple equation that seeks to explain a key macroeconomic relationship. More
recently Rudebusch and Svensson (1998) reinforced that the Taylor rule stabilizes
both inflation and output reasonably well in varieties of macroeconomic models.
Orphanides (2007) argues that the Taylor rule offers a simple and transparent
framework with which to organize the discussion of systematic monetary policy,

10
but on the other hand is not likely to be useful using real-time data. On a
conference held on John Taylor’s contribution to monetary theory and policy on
October 12, 2007, Donald Kohn, the vice chairman at that time of the federal
reserve bank of Dallas, also commented on the simplicity of the Taylor rule as it is
helpful in the central bank’s communication with the general public and that it
helps financial market participants from a baseline for expectations regarding
future courses of monetary policy. He however also mentioned that the Taylor
rule has some limitations, including that fact that it only captures small number of
variable, that are not enough to describe fully the state of a complex economy like
that of the United States. But despite its flaws as a practical tool, it is a quite
useful tool in evaluating historical monetary policy regimes. Judd and Rudebusch
(1998) and numerous others have estimated values of key parameters using data
for previous Federal Reserve governorships, using the Taylor rule.

The original Taylor rule (1993) in itself is backward-looking, but has over the
years undergone various modifications as researchers try to make it more
appropriate to suit the different types of economies. Due to rational expectations
in macroeconomic models, one major modification to the original Taylor rule has
been to incorporate forward-looking behaviours of central banks reaction
functions. The forward-looking models are often used by forecasters, in making
the short-term interest rate a function of central bank expectations of output gap
and inflation rather than their contemporaneous values. As monetary conditions
are also influenced by exchange rate movements, another major modification to
the original Taylor rule has been the incorporation of some form of exchange rate
variable into the Taylor-type equations. But several studies however, suggest that
the inclusion of an exchange rate variable in a Taylor-type equation is not helpful
for inflation and output stabilisation, because exchange rate misalignments could
be very protracted, and would not seem as a desirable feature to rely on a general
rule that would significantly bias monetary policy.

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3. Earlier studies

Over the past two decades, the Taylor rule, have attracted increased attention of
economic analysts, policymakers, and the media all over the globe. The rule has
become more appealing in recent times with the apparent breakdown in the
relation between money growth and inflation as proposed in Friedman’s k-percent
rule. The historical analysis and the reaction function are often employed to
conduct empirical analyses in the Taylor rule framework.

In recent years there have also been studies conducted on developments of trends
and cycles in real GDP and inflation in the European Monetary Union (EMU)
member countries under the framework of the Taylor rule. For example, Crowley
and Lee (2008) conducted an empirical studies based on the Taylor rule and in
combination with counterfactual statistical techniques, on the extent to which the
European Central Bank (ECB) respond to evolving economic conditions in its
member states as opposed to the euro area as a whole. Their results indicated that
the ECB’s monetary policy rates have been particularly close to the interest rates
of Germany, and countries with similar economic conditions to that of Germany –
this includes Austria, Belgium, the Netherlands and France. However, their
coefficient estimates for the future inflation variable varied widely across the
member countries. The estimate for the euro area as a whole differed remarkably
from those of individual countries, with the estimates for Finland, Greece, Ireland,
Italy and Spain to be relatively higher, suggesting aggressive responses to
expected inflation from these countries. They suggested in their study that since
the economies of the euro area have been quite unsynchronized, ECB policy
actions, might have been adequate for the euro area as a whole, but too loose
especially for faster growing countries such as Greece and Ireland and too tight
for slower growing countries, such as France.

However, there have only been few studies done solely on Ireland’s individual
membership in the EMU under the framework of the Taylor rule. For example,
Honohan (2006) looked at whether both the exchange rate and interest rate have
had the effect of increasing the scale and frequency of exogenous shocks hitting
the Irish economy. In particular how key variables in the remainder of the

12
economy – which are the share of construction in total employment, house prices,
inward migration and labour competitiveness – have responded to the largest of
these shocks. He found that the implementation of the euro has triggered sizeable
exogenous shocks to the Irish economy – in particular interest rate shocks. He also
confirms that the interest rate movements have deviated widely from what a
standard Taylor monetary policy rule would have counselled. The most important
shock, according to him, has been associated with the large and sustained initial
fall in nominal interest rates in the start of the EMU, which have had lasting
effects on property prices, construction activity and the capacity of the labour
market to absorb sizeable net immigration, despite a sharp deterioration in wage
competitiveness since 2002. According to Honohan, the Taylor rule stipulates an
interest rate almost 5% higher than that set by the ECB during the years 2000-
2005. Given that the rate was set at 1% throughout 2005 the ECB would have to
raise it to 6% to accommodate the Irish economy and send nothing less but a
shock to the rest of the Euro area economies.

4. Empirical Section

4.1 The Regression Model

For our purpose, we would rewrite equation (1) above into a suitable regression
model as follows:

it   0   1 t   2 y t   t

(2)

where:  0  (r * 1 *) , 1  (1  1 ) ,and  2  2 . The equation:

 0  (r * 1 *) provides estimates of the weights on inflation and output in the

Taylor rule and on the speed of adjustment to the rule. The nominal interest rate, it

, is the dependent variable, while the inflation,  t , and the output gap, yt , are the

13
independent variables. This specification of the Taylor rule does not contain the
interest rate smoothing term.3

The four parameter value for, r * ,  * , 1 and  2 were taken by Taylor in his 1993
presentation as, respectively, 2 percent, 2 percent, 0.5 and 0.5, under the
assumption that the central bank has the information on current output and
inflation, and strictly following the rule. The parameter values were taken as
 0  1,  1  1,5 and  2  0,5 , but if this is not the case, then following
conditions must hold: 1  1 and  2  0 , otherwise the system would be
unstable. Taylor (1999) referred to the second condition as the “Taylor Principle”.
Also, if the intercept in Equation 2 is negative then either real interest rate is
negative or target level of inflation is high. We have used the 2 percent parameter
for  * and the averages over r * for every sample in our model. We estimate the
real interest rate by subtracting the available inflation rate values from the
available nominal interest rate values. Our estimate of the average interest rate for
Ireland is 6,7 percent between the period of 1990 and 2000.

4.2 Regression Technique and problems

Our objective is to estimate a Taylor rule for Ireland and not the actual policy
reaction function, hence our task will be to estimate the coefficients 0 , 1 and  2
in equation 2 by running a simple Ordinary Least Square (OLS) regression on it
for the period prior to the EMU era. Once we have the values for these three
coefficients from running a regression on the contemporaneous data between 1990
and 2000, we will then use average values for inflation,  t , and the trend GDP, y t
for the period between 2000 and 2009 to manually calculate an estimate of a
nominal interest rate for Ireland.

3
Central banks often adjust interest rates by slowly bringing the rates towards a desired target
level. To allow for interest rate smoothing, some researchers incorporate an interest rate smoothing
term (see for instance, Judd and Rudebusch (1998)).

14
However, in running an Ordinary Least Square (OLS) regression, we are aware of
certain problems that could arise and make our regression results biased and
inconsistent:

The problem of non-stationary series (or unit root): For an OLS estimation on
a time series data to be valid, the error term must be time-invariant, that is,
stationary. In a situation where we have unit roots, the values from previous
periods in the time series data are carried forward to current periods. As such the
values of the random error will never fade away, and the continuous build-up of
the errors will create problems that the non-stationary series will tend to towards
an infinite variance. Furthermore, if the dependent variable and the explanatory
variables in a regression are both non-stationary, the model will have spuriously
insignificant result and high R 2 even if the two variables are unrelated. To
address this problem we will take first differences in the time series data in order
to eliminate both the autoregressive component and the unit root, which will in
turn lower the R 2 dramatically.

Simultaneity problem: This is a case in which we have some of the regressors

that are endogenous (or when not all the explanatory variables are exogenous) and
are therefore likely to be correlated with the error term. To identify this problem,
we will run a Hausman specification error test to check whether an endogenous
regressor is correlated with the error term.4 If we identify such a problem, we will
correct it by resorting to a two-stage least square (2SLS) approach; whereby we
regress each endogenous variable on all the exogenous variables of the system,
and then use the predicted values of the endogenous variables to estimate the
structural equations of the model.

Autocorrelation problem: one common problem in time series analysis is a

problem of positive first-order autocorrelation, which arise when the error term in
one time period is positively correlated with the error term in the previous time
period. This leads to downward-biased standard errors and thus to incorrect
statistical test and confidence intervals. We will test for this problem by

4
The null hypothesis of no bias in the OLS estimate can be rejected with a probability of 0.003 in
conducting a Hausman test.

15
conducting the Durbin-Watson test at a 5 or 1% level of significance. We will
correct this problem, by regressing the dependent variable on its value lagged one
period, the explanatory variables of the model and the explanatory variables
lagged one period.

4.3 Statistical sources and limitations

The main part of the raw data sample was obtained from the Central Statistical
Office (CSO) of Ireland and Eurostat. Data spanning pre-EMU period was
obtained directly from CSO Ireland with a total of 24 observations, whilst data
spanning the transition and post-EMU period was obtained through Eurostat with
a total of 52 observations (see tables 1 and 2 respectively). We have divided the
regression analysis into two parts: (1) preceding EMU period and (2) the transition
to EMU period. The data sample consists of only a small number of observations
consisting of monthly observations on GDP, inflation and nominal interest rate
covering the period 1990-1995 from the Irish Central Statistical office (CSO), and
quarterly observations on the same variables covering the period 1997-2009 from
the Eurostat database. The GDP is measured in millions of euros, while the
inflation- and nominal interest rates are measured in percentage points. Data on
GDP between the first quarter of 1996 and the last quarter of the same year is
unavailable from both institutions.

The Taylor rule requires quarterly series, which make it rather difficult to estimate
the dynamic version of the model. For this reason, and due to the unavailability of
quarterly data between the periods of 1990-1995, we resorted to interpolation in
order to derive quarterly data from the available monthly data.5 Beside the three
mentioned variables, the Taylor rule also requires expected inflation, potential
GDP, and real interest rate, which are unavailable from our respective data
sources. The lack of data on expected inflation is due to the fact that the Irish
Central Statistical Office (CSO) never did forecasts during the pre EMU era.6 We

5
We averaged in excel all the variables that are in monthly series over three months of each
quarter, by creating in the data sheet with appropriate in the last month of each quarter.
6
We assume that an appropriate inflation target for Ireland is 2% as the SCB and the Swedish
inflation target levels.

16
applied the Hodrick-Prescott filter (HP-filter) to the GDP data in order to extract a
trend GDP from the actual GDP. The filter, decomposes the time series data into
growth and cyclical components, and interprets the growth component to be the
potential GDP, which is measured as the percentage deviation from the fitted
trend. Figure 1 in the appendix shows the actual series and the fitted trends for
output.

The reason we chose the filter approach over the Okun’s law –and production
function approaches is mainly due to three of several reasons. (i) It is a convenient
method that works well on historical time-series data. (ii) It only interprets one
economic indicator. (iii) It follows the data closely which renders the bias of
analytical judgement void. This being an empirical study gives a strong base for
its use, but we are however aware of some significant shortcomings in using the
HP-filter. (i) It does not account for trends in the other economic factors occurring
outside of the GDP, such as structural changes in the factor of production. (ii) It
has some troubles with estimating precise values due to kinks/disturbances in the
economic cycle. (iii) The filter proposes a trend rather than potential GDP because
it does not yield an estimate level of output that is consistent with stable inflation.
We have deemed the time span as well as the relatively stable history of Ireland’s
economy to be adequate for the implementation of the filter. However, to avoid
non-stationary trends in the time series data, we have resorted in taking the first
differences on all the variables in order to eliminate the problems that could arise
from the presence of a unit root. Figure 2 in contrast to Figure 1 (see appendix),
shows the improvement made in the data after taking the first difference.

The inflation was calculated from the two CPI-indexes which were available at
both Eurostat and CSO Ireland. The first data period is from 1990-2000 with the
CPI base from 1989 and the second is from 2000 to 2009 with a CPI base from
1996. The inflation was calculated by subtracting the CPI from the current year by
the preceding year. Then the sum was divided by the CPI given from the
preceding year and the result was multiplied by a 100. This gives a percentile
indicator of the inflation change for each quarter. Figure 3 (see appendix) shows
the trend in inflation between 1990 and 2009. The summary of the data sets can be
viewed in the tables below. They are divided into two, in order to give a clearer

17
and simplified insight into the variables present. The scope and time span of the
study becomes well defined as you can view the differences of the two periods
accordingly.

Table 1: Descriptive statistics for data between 1990-1995

Variable Obs Mean Std. Dev. Min Max

Inflation 24 0.0061417 0.0035812 -0.0018 0.0134

Real GDP 24 17904.35 1425.236 16433.25 20542.75

Trend GDP 24 17904.33 1336.906 15940.24 20285.62

GDP Gap 24 -0.0000257 0.0225438 -0.0410691 0.0490878

Real 24 0.0865125 0.023485 0.0545 0.1357

Interest rate

Table 2: Descriptive statistics for data between 1997-2009

Variable Obs Mean Std. Dev. Min Max

Inflation 52 0.0076923 0.0128637 -0.0118 0.08

33004.92
Real GDP 52 6432.052 20593 42602

Trend GDP 52 33004.92 6308.019 20968.97 40574.63

GDP Gap 52 -0.0002787 0.0271283 -0.0638732 0.0643157

Real 52 0.0347154 0.0188033 -0.05 0.0655

Interest rate

4.4 Choice of time period

The time period chosen for the study is 1990-2009. This is based on the fact that
we can observe an adequate amount of data before and after Ireland’s entry to the
EMU system. The main argument for conducting the study through such a time
period is to give reasonable estimate of the weights on inflation and output gap.
Furthermore it gives weight to the whole analysis as a broad time spectrum is used

18
which can therefore help remove possible discrepancies from the data. Another
aspect is that studies tampering the matter of the Taylor rule and Ireland did not
include this specified time period.

5. Regression result and analysis

To estimate what nominal interest rate Ireland would have set if it weren’t in the
EMU, we adopted the Taylor rule methodology. We have estimated the Taylor
rule coefficients by conducting an OLS regression on quarterly data for the period
1990-1995 and 1997-2000 respectively. We then used the coefficients from these
regressions as weights on the averages of inflation and GDP gap for the periods of
1990-2009. Table 3 and 4 report the estimates from the regressions done on the
data for 1990-1995 and 1997-2000 respectively. Table 5 shows the estimated
nominal interest rate for Ireland for the whole sample, with averages over the
variables used in the manual calculation of the interest rate.

Table 3: Regression result 1990-1995

Variable Coefficient Standard Error t

Inflation -0.0800713 0.3687862 -0.22

Gap 0.0405271 0.0427637 0.95

intercept -0.0022439 0.0021873 -1.03

F-statistic: 0.46, Number of observations:24

Table 4: Regression result 1997-2000

Variable Coefficient Standard Error t

Inflation -0.1207992 0.2029273 -0.60

Gap 0.0607676 0.0695343 0.87

intercept -0.0004262 0.0017514 -0.24

F-statistic: 0.38, Number of observations:16

19
Table 5: Estimation table
Variables 1990-1995 1997-2000 2001-2009 2009

Real interest rate 0.0865 0.0465 0.0294 0.0269

Inflation 0.0061 0.0078 0.0078 -0.0062

GDP Gap -0.0000257 -0.000996 0.0000402 -0.0460043

Estimated nominal
10.7 6.7(6.7) 5.0(5.1) 4.7(4.7)
interest rate
Note: The variables (real interest- and inflation rates in percentage points) are calculated as the
averages over the four-quarters from the first quarter to the last quarter of every sample (i.e.1990-
1995, 1997-2000 and 2001-2009). In parenthesis are the nominal interest rates calculated using the
coefficients extracted from the second regression. The end-of-sample inflation is average inflation
over the final four quarters of 2009. The estimated nominal interest rate is circa 7.5%, calculated
from the averages of 10.7, 6.7 and 5.0.

We did simulations using our estimated Taylor rule coefficients from the first
regression and paired it with simulations with induced Taylor rule coefficients to
see how the interest rate trends would have looked like had Ireland control over its
monetary policy and if they strictly followed the Taylor rule. We have these
simulations in figures 3 (see appendix). Not surprisingly we can see from figure 3
that Ireland should have had an interest rate some where between 8-10 percent for
at least some time if it hadn’t joined the EMU in 1999. Our calculation is
somewhat consistent with what figure 4 in the appendix predicts. We could then
conclude that with the booming economic activities in Ireland before and after its
entry into the EMU, the country should have been operating under interest rates
far over the ECB’s average. Plotting an induced Taylor rule in figure 4, was more
of a guide to see if we had used the rule properly.

The results from both regressions show low statistical significance levels for the
Taylor rule coefficients. In any case, our task is to use the Taylor rule framework
to estimate the weights on inflation and GDP gap rather than testing whether the
Taylor rule holds for Ireland. Besides the estimated weights on inflation and GDP
gap are to some extent reliable, because the results from the Durbin-Watson
coefficient tests conducted to check for first-order autocorrelation indicates

20
acceptable levels of autocorrelation.7 Table 6 (see appendix) shows the result from
the Durbin-Watson test. We have not used the ARMA model, which might have
entirely eliminated the problem. However, most studies suggest that the problem
of autocorrelation often imply model misspecification, which may arise from
missing variables. In our case we think this problem arose most likely from the
use of the HP-filter, which does not capture other trends in the other economic
factors occurring outside of the GDP. Another explanation for the autocorrelation
might be due to the Irish central bank’s practice of interest rate smoothing.

We also conducted a Hausman test which showed no sign of simultaneity. The

residual series from these estimated coefficients in equation 2 are stationary as the
null of the unit root in the Dickey-Fuller test is easily rejected at conventional
levels of significance. The results from the Dickey-Fuller tests are shown in tables
7 and 8 (see appendix) for the respective periods.

6. Conclusion

We began the study with a goal of estimating a counter-option nominal interest

rate to that of the ECB average. Our results indicate that an appropriate nominal
interest rate for Ireland should be roughly 7.5 percent, rather than the circa 3
percent fixed by the European Central Bank upon its entry into the EMU. This is
consistent with Honohan’s prediction of an approximate 6 percent. We conclude
therefore that the interest rate in the EMU is not set in response to the economic
realities in Ireland.

In light of the estimated data it is relevant to remember the criteria for the
introduction of the Euro, that is to say, the creation of an Optimum Currency
Area. The criteria concentrate mainly on the aspects of intra-European trade,
mobility of the European labour force, similarity of economic structure and fiscal
federalism. Albeit in a state of probing, the EMU was implemented as a means to

7
The value of d in the Durbin-Watson coefficient test for first-order autocorrelation ranges from 0
to 4. A value of 2 indicates no autocorrelation; 0 indicates positive autocorrelation; and 4 indicates
negative autocorrelation.

21
fulfil the political goals of the EU through economic co-integration. As previously
stated the union would, amongst others, lead to benefits of increased trade,
monetary efficiency gain and countries with a history of volatile inflation would
experience a stabilizing effect through the common currency8. The counter
argument for the introduction of the common currency is best described by the
term economic stability loss. Namely, the ability of a country to counter-act
cyclical changes as well as asymmetric shocks in the economy is given to a
supranational entity, the ECB. The main tool for conducting such policy was
through a nation’s central bank and the broad spectrum associated with monetary
policy. The lack of an independent interest rate is in theory supposed to be offset
by a pro-active fiscal policy. This argument is not approved by post-Keynesian
economists who argue that the Maastricht Treaty does not allow for a possibly
needed fiscal deficit. Furthermore, the union may become characterized by
specialization as explained by the Heckscher-Ohlin model which may worsen
asymmetrical shocks when they occur. This may be the case with Ireland. An
example would be that the country experienced another inflation rate trend than
that of Netherland although both countries’s had to pass the admission criteria for
the EMU.

From our findings the loss of autonomy over Ireland’s monetary policy has
complicated its economic management. In theory the fiscal policy should sustain
the economy in the absence of a monetary policy. In light of the optimum
currency area the Irish case has shown that due to circumstances as demographics,
booming housing and the export industry, asymmetric shocks are inevitable as the
countries within the EMU are unsynchronized. Therefore it should be stated that
the EMU should introduce a type of federal budget system similar to that of the
United States in order to minimize the asymmetrical shocks.

8
Optimal Currency Areas* (2002); Alberto Alesina, Robert J. Barro, Silvana Tenreyro; page 7.

22
References

Blanchard, Oliver, (2006), Macroeconomics, 4th Edition, Pearson Publication

Carare, Alina and Robert Tchaidze, (2005), ” The Use and Abuse of Taylor Rules:
How Precisely Can We Estimate Them?”, IMF Working Paper, WP/05/148

Chamie, Nick, Alan DeSerres and René Lalonde,(1994), “Optimum Currency

Areas and Shock Asymmetry: a comparison of Europe and the United States”,
Bank of Canada, Working paper 94-1.

Crowley, Patrick M. and Jim Lee, (2008), “ Do All Fit One Size? An Evaluation
of the ECB Policy Response to the Changing Economic Conditions in Euro Area
Member States” Texas A&M University-Corpus Christi

Gotfries, Nils, (2003), “Ränta och Växelkurs I och Utanför EMU” Ekonomisk
Debatt 2003:4

Judd, John P. and Glenn D. Rudebusch, (1998), “ Taylor’s Rule and the Fed:
1970-1997”, FRBSF Economic Review 1998:3.pp. 3-16

Honohan, Patrick and Anthony J. Leddin, (2006), “Ireland in the EMU: More
Shocks, Less Insulation?” Economic and Social Review, Vol.37, No. 2,
Summer/Autumn, pp. 263-294.

Honohan, Patrick and Philip R. Lane , (2004), “Exchange Rates and Inflation
under EMU: An update”, Centre for Economic Policy Research Discussion, Paper
4583, August.

Kenneth Kuttner, (1994), “Estimating Potential Output as a Latent Variable”,

Journal of Business and Economic Statistics, vol. 12, no. 3 (July).

23
Mundell, R. ,(1961), “ A Theory of Optimum Currency Area”, American
economic Review 51:657-665.
Orphanides, Athanasios, (2007), “Taylor Rules” Board of Governors of the
Federal Reserve System (January)

Taylor, John B., 1993, “Discretion Versus Policy Rules in Practice,” Carnegie-
Rochester Conference series on Public Policy, Vol 39 (December), pp. 195-214.

Electronic Sourses

http://www.prospect-magazine.co.uk/article_details.php?id=5195
http://ec.europe.eu/economy_finance/publications/countryfocus_en.htm

24
 Appendix
Descriptive statistics
Figure 1: GDP and trend GDP between 1990- 2009

50000
GDP and GDP Trend
40000 GDP

30000 Trend
GDP
20000

10000

0
1995
1990
1991
1992
1993
1994

1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
Year

Figure 2: GDP and trend GDP between 1990- 2009, after taking the first difference

10,00% GDP gap differentiated

8,00%
6,00%
4,00%
GDP gap
2,00%
0,00%
-2,00% GDP gap
-4,00% differentiated
-6,00%
-8,00%
1991Q1

2001Q1
1990Q1

1992Q1
1993Q1
1994Q1
1995Q1
1996Q1
1997Q1
1998Q1
1999Q1
2000Q1

2002Q1
2003Q1
2004Q1
2005Q1
2006Q1
2007Q1
2008Q1
2009Q1

Figure 3: Inflation trend between 1990-2009

Inflation
10,00%

8,00%

6,00%

4,00%
Inflation
2,00%

0,00%

-2,00%
1990
1991
1992
1992
1993
1994
1995
1995
1996
1997
1998
1998
1999
2000
2001
2001
2002
2003
2004
2004
2005
2006
2007
2007
2008
2009
Year

Sources: Eurostat and CSO Ireland. Note: the downward kink in figure 1 indicates the
unavailability of data for 1996.

25
Regression diagnoses
Table 6: The Durbin-Watson test result

Test 1990-1995 1997-2000

Durbin-Watson statistic 1.436003 1.270489

Table 7: Dickey-Fuller test results for period 1990-1995

Variable Test Statistic Z(t) 5% Critical Value P-value for Z(t)

Gap differentiated -5.593 -3.000 0.0000

Inflation
-8.683 -3.000 0.0000
differentiated
Interest rate
-3.271 -3.000 0.0162
differentiated

Table 8: Dickey-Fuller test results for period 1997-2000

Variable Test Statistic Z(t) 5% Critical Value P-value for Z(t)

Gap differentiated -9.002 -3.000 0.0000

Inflation
-5.835 -3.000 0.0000
differentiated
Interest rate
-2.754 -3.000 0.0652
differentiated
Note: the Z(t) for the differentiated interest rate passed a 10% critical value which was -2.630.

Simulation
Figure 4: Estimated Taylor Rule diagram

12,00%
Taylor Rule 1990-1995
10,00%

8,00%
Actual
6,00%

4,00% Induced
Taylor rule
2,00%

0,00%

-2,00%
1990 1991 1992 1993 1994 1995

26
The empirical model.

The Taylor rule as presented by Taylor (1993) can be expressed as follows:

it  r *   t  1 ( t   * )   2 y t

(1)

Where, it represent the nominal interest rate taken as monetary policy instrument

at time t,  t the average inflation for the previous four quarters (including the

current one) at time t, and y t  (Yt  Yt * ) / Yt * represents the GDP gap or trend

GDP (the parameters r * =  * =2% and 1 =  2 =0.5%, were given by Taylor) It is

should be fairly straightforward to directly conduct a regression on equation (1) as
written in the following model:

it   0   1 t   2 ( t   * )   3 y t (2)

Where we have,  0  r * ,  1  1,  2  1 , and  3  2 . Since we have two constant

terms r * and  * , it would be impossible to estimate them independently and

simultaneously. Also, the  t and the ( t   * ) variables are nearly identical,

since  * is a constant. As a result we will have a total of two explanatory

variables that are perfectly linearly correlated. Thus proceeding with the model in
equation (2), will make it impossible for us to isolate the effects of these two
individual explanatory variables ( i.e r * and  t ) on the dependent variable ( it ),
because the system of normal equations will contain at least two equations that are
not independent, as such yielding OLS coefficients that may be statistically
insignificant. To make equation (1) suitable for regression and to avoid the
problem of perfect multicollinearity, we transformed the functional relationship
and to drop one of the highly collinear variables, that is, the ( t   * ) term.
Rearranging equation (1):

itT  r *   t  1 t  1 *  2 y t

27
itT  r *   t (1  1 )  1 *   2 y t (1)

Now we can form the regression specification model:

it   0   1 t   2 y t   t (3)

Where:

 0  (r * 1 *) (4)

1  (1  1 ) (5)

 2  2 (6)

If the central bank is strictly following the Taylor rule, then the parameter values
will become  0  1,  1  1,5 and  2  0,5 in equations 4, 5 and 6 respectively.

But if this is not the case, then following conditions must hold: 1  1 and  2  0 ,
otherwise the system would be unstable. Taylor (1999) referred to the second
condition as the “Taylor Principle”. If the intercept in Equation (3) is negative
then either real interest rate is negative or target level of inflation is high.

The manual calculation of the Taylor rule

i9095  0.0865  0.0061  1.0800713 (0.0139 )  0.0405271 (2.57 5 )  0.1076  10 .7%

i9700  0.04653  0.0078  1.0800713 (0.0122 )  0.0405271 (9.96 4 )  0.0674  6.7%
i0109  0.02936  0.0078  1.0800713 (0.0122 )  0.0405271 (4.02 5 )  0.0503  5.0%

iestimate  (10 .7%  6.7%  5.0%) / 3  7.5%

28