Definition: Taylor rule is a monetary policy guideline that suggests how central banks should react to economic changes. Basically, itís a general rule of thumb to help predict how interest rates will be affected by changes in the economy. For instance, it prescribes how the Federal Reserve should adjust interest rates to stabilize inflation and economic volatility.
What Does the Taylor Rule Mean?
The Taylor rule was introduced by John Taylor, professor of economics at Stanford University, based on his empirical study on the FEDís monetary policy between 1987 and 1992. Itís a simple rule of monetary policy intended to suggest a systematic way of determining the interest rates as the economic conditions and macroeconomic activities change over time.
At its base, the Taylor Rule formula defines inflation as the difference between the nominal and real interest rate. Thus, it allows central banks to help regulate the economy through the manipulation of interest rates. As inflation rates increase and full employment is exceeded, interest rates should be increased. On the other hand, as inflation and employment decrease, so should the interest rates.
The rule establishes a framework for the historical analysis of monetary policy.
Letís look at an example.
The Taylor rule suggests a target for the level of Fedís nominal interest rates, which takes into account the current inflation, the real equilibrium interest rate, the inflation gap adjustment factor, and the output gap adjustment factor. The inflation gap adjustment factor is the deviation from the target inflation and it suggests the increase or decrease in the interest rates if the inflation is higher or lower than the target inflation, respectively.
The output gap adjustment factor is the deviation from the target GDP and it suggests the increase or decrease in the interest rates if the actual GDP is higher or lower than the target GDP, respectively.
Given all the above, an expansionary monetary policy is suggested by the Taylor rule when inflation is below the target or when production is less than the potential output. Conversely, when the inflation is above the target, the rule suggests that the FED take a contractionary monetary policy approach.
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