Taylor rule

The Taylor rule is a monetary policy targeting rule. The rule was proposed in 1992 by American economist John B. Taylor for central banks to use to stabilize economic activity by appropriately setting short-term interest rates. The rule considers the federal funds rate, the price level and changes in real income. The Taylor rule computes the optimal federal funds rate based on the gap between the desired (targeted) inflation rate and the actual inflation rate; and the output gap between the actual and natural output level. According to Taylor, monetary policy is stabilizing when the nominal interest rate is higher/lower than the increase/decrease in inflation. Thus the Taylor rule prescribes a relatively high interest rate when actual inflation is higher than the inflation target. In the United States, the Federal Open Market Committee controls monetary policy. The committee attempts to achieve an average inflation rate of 2% (with an equal likelihood of higher or lower inflation). The main advantage of a general targeting rule is that a central bank gains the discretion to apply multiple means to achieve the set target. The monetary policy of the Federal Reserve changed throughout the 20th century. Taylor and others evaluate the period between the 1960s and the 1970s as a period of poor monetary policy; the later years are typically characterized as stagflation. The inflation rate was high and increasing, while interest rates were kept low. Since the mid-1970s monetary targets have been used in many countries as a means to target inflation. However, in the 2000s the actual interest rate in advanced economies, notably in the US, was kept below the value suggested by the Taylor rule. The Taylor rule represents a rules-based approach to monetary policy, standing in contrast to discretionary policy where central bankers make decisions based on their judgment and interpretation of economic conditions. While the rule provides a systematic framework that can enhance policy predictability and transparency, critics argue that its simplified formula—focusing primarily on inflation and output—may not adequately capture important factors such as financial stability, exchange rates, or structural changes in the economy. This debate between rules and discretion remains central to discussions of monetary policy implementation.

Equation According to Taylor's original version of the rule, the real policy interest rate should respond to divergences of actual inflation rates from target inflation rates and of actual Gross Domestic Product (GDP) from potential GDP:

i t = π t + r t ∗ + a π ( π t − π t ∗ ) + a y ⋅ 100 ( Y t − Y ¯ t ) / Y ¯ t . {\displaystyle i_{t}=\pi _{t}+r_{t}^{*}+a_{\pi }(\pi _{t}-\pi _{t}^{*})+a_{y}\cdot 100(Y_{t}-{\bar {Y}}_{t})/{\bar {Y}}_{t}.}

In this equation, i t {\displaystyle i_{t}} is the target short-term nominal policy interest rate (e.g. the federal funds rate in the US, the Bank of England base rate in the UK), π t {\displaystyle \pi _{t}} is the rate of inflation as measured by the GDP deflator, π t ∗ {\displaystyle \pi _{t}^{*}} is the desired rate of inflation, r t ∗ {\displaystyle r_{t}^{*}} is the assumed natural/equilibrium interest rate, Y t {\displaystyle Y_{t}} is the actual GDP, and Y ¯ t {\displaystyle {\bar {Y}}_{t}} is the potential output, as determined by a linear trend. 100 ( Y t − Y ¯ t ) / Y ¯ t {\displaystyle 100(Y_{t}-{\bar {Y}}_{t})/{\bar {Y}}_{t}} is the output gap, in percentage points. Because of i t − π t = real policy interest rate {\displaystyle i_{t}-\pi _{t}={\mbox{real policy interest rate}}} ,

… excerpt ends here. Continue reading the full article.