Taylor Rules and Macroeconomic Instability or How the Central Bank Can Pre-empt Sunspot Expectations

This paper derives new results on the e¤ects of employing Taylor rules in economies that are subject to real market imperfections such as production externalities. Taylor rules that aggressively respond to output can eliminate sunspot equilibria that arise from the increasing returns. The paper also ...nds that rules which should be chosen (avoided) in perfect market environments often yield (ensure) multiple (unique) rational expectations solutions in alternative settings. Therefore, exact knowledge on the degree of market imperfection may be pivotal for robust policy advice. ¤I would like to thank Michael Burda, Roger Farmer, Andreas Schabert and two anonymous referees for helpful comments. Remaining errors are, of course, my own. I would also like to thank the UCLA Economics Department for its hospitality. This paper was written while Weder was a DFG Heisenberg Fellow.