# The Euro and Taylor rule

March 30, 2011 Leave a comment

The Taylor rule (see http://www.stanford.edu/~johntayl/Papers/Discretion.PDF) is a formula to estimate the best interest rate for a central bank. I don´t believe very hard in it. But I think that it is useful in comparing the different cycle of economies members of a monetary union. If we use the same parameters calculating the optimal interest rate for different countries, the interpretation of the result can only be straightforward.

Taylor rule says that the optimal interest rate is a function of the differences between the current growth rate ant the desired one, and between current inflation and the desired inflation.

In the figure, I suppose a optimal GDP growth of 2% for Germany and a 2,5% for Spain. For both an optimal inflation 2%. Dotted line is the actual rate of ECB.

Easy is to see that the euro has been very pro-cyclical for both countries! but for opposed reasons, indeed: except when the crisis arrived in 2007

The ECB rate has been to high for Germany and too low for Spain before 2006. In 2006, the ECB rte is too low for both countries; after 2007, to high…

(I´m sorry not to be able to get a better image)