How to Use the Taylor Rule

The Taylor rule sets the policy rate as the neutral real rate plus current inflation plus half the inflation gap plus half the output gap.

The Taylor Rule formula

i = r* + π + 0.5(π − π*) + 0.5(output gap)   |   r* is the neutral real rate, π* is the inflation target

Calculator

Enter the neutral real rate, inflation, the inflation target and the output gap to get the rate the rule prescribes.

Neutral real rate (r*)

The real policy rate that neither speeds up nor slows the economy. The question normally hands it to you.

Current inflation (π)

The inflation rate running right now, not the one the central bank wants.

Inflation target (π*)

The rate the central bank is aiming at.

Output gap

(Real GDP − potential GDP) ÷ potential GDP × 100. Negative when output sits below potential.

Taylor rule policy rate

7.5%

Adding the neutral real rate, current inflation and half of each gap prescribes a nominal policy rate of 7.5%.

Inflation gap: 2%
What the inflation gap adds: 1%
What the output gap adds: 0.5%
Implied real policy rate: 3.5%
Stance the rule prescribes: Contractionary

How to calculate Taylor Rule, step by step

1
Start from the neutral real rate. r* is the real policy rate that neither speeds up nor slows the economy, and the question will normally give it to you.
2
Add current inflation. Adding π turns the real anchor into a nominal rate, which is what a central bank actually sets.
3
Add half the inflation gap. Inflation gap = π − π*. Inflation above target pushes the prescribed rate up by half the overshoot.
4
Add half the output gap. Output gap = (real GDP − potential GDP) ÷ potential GDP × 100. A positive gap adds to the rate and a negative gap subtracts.
5
Read the stance. Subtract inflation from the answer to get the implied real rate, then compare it with r*. Above r* is contractionary.

Worked example: Taylor Rule

Take a neutral real rate of 2%, current inflation of 4%, an inflation target of 2%, and an output gap of +1%. The rule gives i = 2 + 4 + 0.5(4 − 2) + 0.5(1) = 2 + 4 + 1 + 0.5 = 7.5%. The inflation gap contributes 1 percentage point and the output gap contributes 0.5. Subtracting inflation leaves an implied real policy rate of 7.5% − 4% = 3.5%, which sits above the 2% neutral rate, so the rule is prescribing a contractionary stance.

Taylor Rule questions

Why does the rule raise the nominal rate by more than the rise in inflation?

Inflation enters twice, once on its own and once inside the inflation gap, so one extra point of inflation lifts the prescribed rate by 1.5 points. Moving the nominal rate by more than inflation raises the real rate, which is what makes the rule stabilizing.

What do the 0.5 weights mean?

They set how hard the central bank leans on each gap. A larger weight on the inflation gap means a sharper response to inflation, and different versions of the rule use different weights.

Do central banks actually follow the Taylor rule?

No. It works as a benchmark rather than a mandate, used to judge whether the policy rate looks high or low given the inflation and output gaps at the time.

What happens when the rule prescribes a negative rate?

A deep recession with inflation below target can push the prescribed rate below zero, which policy cannot easily deliver because savers can hold cash instead. That is the zero lower bound, and it is why other tools get used at the bottom of a slump.

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Last updated August 1, 2026

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