Are monetary-policy reaction functions asymmetric?: The role of nonlinearity in the Phillips curve

This paper investigates the implications of a nonlinear Phillips curve for the derivation of optimal monetary policy rules. Combined with a quadratic loss function, the optimal policy is also nonlinear, with the policy-maker increasing interest rates by a larger amount when inflation or output are above target than the amount it will reduce them when they are below target. Specifically, the main prediction of our model is that such a source of nonlinearity leads to the inclusion of the interaction between expected inflation and the output gap in an otherwise linear Taylor rule. We find empirical support for this type of asymmetries in the interest rate-setting behaviour of four European central banks but none for the US Fed.