Hello everyone.

I am somehow new to DSGE modelling and I have a question on the New Keynesian model (sorry if it sounds too basic).

My question is: When there is no Taylor rule in the model, I have the same number of equations and endogenous variables, and so all variables (including interest rate on bonds) are determined by the model. NOW, how can I add a Taylor rule to the model since it doesn’t add any new endogenous variable. Dynare understandably tells me that there is more equations than variables. Even in the case of a shock factor in the Taylor equation it comes with its own equation. (i.e. How will the central bank set the interest on bonds when the later is already determined without the Taylor rule? ) Please guide me on what to do.

My guess is you have a redundant equation included. Walras Law tells us that if N-1 markets clear, the last market is also in equilibrium.

Thank you so much for your reply.

It seems like the interest on bonds in my model is determined by the Euler equation for Bonds and the Government budget constraint. All two of these equations seem necessary and useful in the model and it’s just hard to find a place for the Taylor equation.

That would be strange. The Euler equation usually pins down the real return. The problem is pinning down inflation. Here, the Taylor rule is needed.

This has given me some insight, thanks.

However, if I already have “INFLATION = Pt+1/Pt” and the NK Phillips equation, do those not pin down inflation already?

Sorry for continual questions and thank you again for your time !!

No, this will typically pin down expected inflation, not actual inflation.