taylor rule

Taylor Rule

The Taylor Rule was created by Professor John Taylor, who is currently professor of economics at Stanford. The Taylor Rule is an economic policy rule used to determine the optimal target for setting monetary policy given an inflation goal and a GDP goal. Essentially it takes into account the current inflation rate and the current output (GDP), and then based on those numbers it calculates the appropriate federal funds rate.

The main idea behind the Taylor Rule is to stabilize the economy, by avoiding over stimulating the economy during expansions and preventing sharp declines in the economy during recessions. In other words, when the economy is growing too quickly the Taylor Rule suggests that the central bank should increase the interest rate in order to slow down the growth. Similarly, when the economy is in a recession, the Taylor Rule suggests that the central bank should reduce the interest rate to stimulate the economy.

The Taylor Rule is composed of two components; the inflation target and the output gap. The inflation target is the Federal Reserve’s desired rate of inflation based on their dual mandate of promoting price stability and maximum employment. The output gap is the difference between current GDP and the potential GDP. Potential GDP is the level of output the economy can sustain for an extended period of time without putting upward pressure on prices (inflation).

To calculate the target federal funds rate, the following equation is used:

Target Fed Funds Rate = the inflation target + the output gap + 2

The “2” that is added to the equation is known as the Taylor Principle and was added to the equation to encourage the Fed to be slightly more aggressive with their interest rate policies.

The Taylor Rule so far has been mostly ignored by the Fed, however some are calling for the Fed to actually look to the Taylor Rule as its guide for setting interest rate policies. The problem is that the Fed is an independent body and thus cannot commit to following any particular economic policy.

Whether or not the Fed ultimately will looking to the Taylor Rule as a guide to its interest rate policy, it remains one of the most important economic policy rules in modern macroeconomic theory. While it is not the only tool that can be used to guide the monetary policy, it has been a useful tool for economists to help understand how monetary policy affects the economy.

Taylors Rule is an economic policy formula designed to help central banks adjust their interest rate decisions in order to keep inflation in check and the economy within a benign growth range. The formula is based on the economic theory of John Taylor, an economics professor at Stanford University, who developed it with the goal of finding mathematical equations to theoretically measure the desired interest rate for a given economic environment.

In essence, Taylors Rule states that the central banks desired target rate for inflation should increase when the inflation rate rises and decrease when the inflation rate falls. The role of the central bank is thus to adjust the interest rate to help achieve the desired inflation rate. For example, if the inflation rate rises above the desired rate, the central bank would raise the interest rate in order to reduce demand and decrease inflation. Conversely, if the inflation rate is falling below the desired rate, the central bank would lower the interest rate to stimulate demand, thus increasing inflation.

Taylors Rule also suggests that, when the economy is growing too quickly, the central bank should raise the interest rate to slow the growth by reducing demand. Conversely, if the economy is slowing too much, the central bank should lower the interest rate to help stimulate demand, thus increasing economic growth.

Taylors Rule has been widely adopted by central banks around the world as a tool for setting interest rates. However, it is important to note that the formula has received criticism for, among other things, potentially leading to excessive rate hikes or rate cuts, depending on economic conditions. Furthermore, some central banks have adopted different variations of the formula, with modifications for individual national economies. As such, Taylors Rule is still a largely theoretical model, and its practical implicationsi remain to be seen.