AP MacroeconomicsMoney & Monetary Policy
Taylor Rule
The Taylor rule is a formula prescribing how a central bank should set the policy interest rate based on inflation gaps and the output gap.
It says the central bank should raise the nominal rate when inflation exceeds its target or output exceeds potential, and lower it otherwise, with weights (typically 0.5 each) on the inflation gap and output gap. It represents a rules-based alternative to discretionary policy and is often used as a benchmark to judge whether the Fed's rate is 'too high' or 'too low.'
Formula / Example
i = r* + π + 0.5(π − π*) + 0.5(output gap), where r* is the neutral real rate and π* the inflation target