Taylor rule

In economics, a Taylor rule is a monetary-policy rule that stipulates how much the central bank would or should change the nominal interest rate in response to divergences of actual inflation rates from target inflation rates and of actual Gross Domestic Product (GDP) from potential GDP. It was first proposed by the U.S. economist John B. Taylor in 1993.^[1] The rule can be written as follows:

In this equation, is the target short-term nominal interest rate (e.g. the federal funds rate in the US), is the rate of inflation as measured by the GDP deflator, is the desired rate of inflation, is the assumed equilibrium real interest rate, is the logarithm of real GDP, and is the logarithm of potential output, as determined by a linear trend. Uses of such a rule include systematically fostering price stability and full employment in reducing uncertainty and increasing credibility of future actions by the central bank. It may also avoid the inefficiencies of time inconsistency from the exercise of discretionary policy.^[2][3]

Interpretation

According to the rule, both a_π and a_y should be positive (as a rough rule of thumb, Taylor's 1993 paper proposed setting a_π = a_y = 0.5). The rule "recommends" a relatively high interest rate (a "tight" monetary policy) when inflation is above its target or when output is above its full-employment level, in order to reduce inflationary pressure. It recommends a relatively low interest rate ("easy" monetary policy) in the opposite situation, to stimulate output. By specifying a_π > 0, the Taylor rule says that an increase in inflation by one percentage point should prompt the central bank to raise the nominal interest rate by more than one percentage point (specifically, by 1 + a_π, the sum of the two coefficients on π_t in the top equation). Since the real interest rate is (approximately) the nominal interest rate minus inflation, stipulating a_π > 0 implies that when inflation rises, the real interest rate should be increased. Sometimes monetary policy goals may conflict, as in the case of stagflation, when inflation is above its target while output is below full employment. In such a situation, a Taylor rule specifies the relative weights given to reducing inflation versus increasing output.

Although the Fed does not explicitly follow the rule, many analyses show that the rule does a fairly accurate job of describing how US monetary policy actually was conducted earlier under Alan Greenspan.^[4][5] 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 did not officially target the inflation rate.^[6][7] This observation has been cited by many economists^[who?] as a reason why inflation had remained under control and the economy had been relatively stable in most developed countries from the 1980s through the 2000s.

During an EconTalk podcast Taylor explained the rule in simple terms using three variables: inflation rate, GDP growth, and the interest rate. If inflation were to rise by 1%, the proper response would be to raise the interest rate by 1.5% (Taylor explains that it doesn't always need to be exactly 1.5%, but being larger than 1% is essential). If GDP falls by 1% relative to its growth path, then the proper response is to cut the interest rate by .5%.^[8]

Critique

Athanasios 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.^[9]

See also

• Monetary policy
• Inflation targeting
• McCallum rule

References

External links

• Resources from John Taylor's web site.
• Federal Reserve paper on the Taylor Rule.