How the Bundesbank really conducted monetary policy

Papers estimating the reaction function of the Bundesbank generally find that its monetary policy from the 1970s to 1998 can be captured by a standard Taylor rule according to which the central bank responds to the output gap and to deviations of inflation from target, but not to monetary growth. This result is at odds with the Bundesbank's claim that it followed a strategy of monetary targeting. This paper analyzes whether this apparent contradiction is due to (a) the use of ex-post data which do not necessarily match policy makers' real-time information sets or (b) the omission of important explanatory variables. Accordingly, we compile a real-time data set for Germany including the Bundesbank's own estimates of potential output and use it to re-estimate the Bundesbank's reaction function. We find that the use of real-time data changes the results considerably. Moreover, when adding the change in the output gap as well as deviations of money growth from target to the set of explanatory variables, we find that both variables are highly significant. This suggests that the Bundesbank took its monetary targets seriously, but also responded to deviations of expected inflation and output growth from target.