Taylor rule Totally Explained

Everything about The Taylor Rule totally explained

The Taylor rule is a modern monetary policy rule proposed by economist John B. Taylor that stipulates how much the central bank should change the nominal interest rate in response to divergences of actual GDP from potential GDP and divergences of actual rates of inflation from a target rate of inflation. The rule can be written as follows:

i_t = pi_t + r_t^* + a_pi  (pi_t - pi_t^* )  + a_y (y_t - ar y_t )

In this equation,

i_t

is the target short-term nominal interest rate (for example the federal funds rate in the US),

pi_t

is the rate of inflation as measured by the GDP deflator,

pi^*_t

is the desired rate of inflation,

r_t^*

is the assumed equilibrium real interest rate,

y_t

is the logarithm of real GDP, and

ar y_t

is the logarithm of potential output, as determined by a linear trend (Taylor, 1993).

Interpretation

According to the rule, both

a_>0

is equivalent to saying that when inflation rises, the real interest rate should be increased.
Although the Fed doesn't explicitly follow the rule, many analyses show that the rule does a fairly accurate job of describing how US monetary policy actually has been conducted during the past decade under Alan Greenspan. Similar observations have been made about central banks in other developed economies, both in countries like Canada and New Zealand that have officially adopted inflation targeting rules, and in others like Germany where the central bank's policy doesn't officially target the inflation rate. This observation has been cited by many economists as a reason why inflation has remained under control and the economy has been relatively stable in most developed countries since the 1980s.

Critique

Orphanides (2003) claims that the Taylor rule can misguide policy makers since they face real time data. He shows that the Taylor rule matches the US funds rate less perfectly when accounting for these informational limitations and that an activist policy following the Taylor rule would have resulted in an inferior macroeconomic performance during the Great Inflation of the seventies.

Further Information

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