A monetary policy reaction function through Taylor rule vision: evidence from Tunisia

The effectiveness of monetary policy instruments and central banks’ interest rate setting behaviour has gained a particular interest amongst any monetary economists. Taylor’s rule is widely used by the monetary economists to forecast short-term interest rate. In this paper, the Taylor rate is calculated and compared to the observed short-term interest rate to evaluate the adequacy of the Tunisian monetary policy. We use a range of Taylor rule specifications and a VAR model approach to analyse the dynamic reaction functions of the Central Bank of Tunisia and for determining the short-term interest rate. Our main findings suggest the importance of domestic aggregates (inflation and output gaps) and neglect the foreign indicators’ effects. Using simulation approach, we found that original Taylor rule sub-estimates interest rate. The main result of our estimation suggests that Taylor rule fails to explain the monetary policy and it should be revised in order to detect economic and financial instability. Indeed, we detect a quite convergence between actual and estimated levels in tranquil economic periods.