Taylor Rule
What is 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.'
Taylor Rule: a worked example
Suppose a central bank's neutral real rate is 2%, its inflation target is 2%, measured inflation runs 5%, and output sits 1% above potential. The rule prescribes i = 2 + 5 + 0.5(5 - 2) + 0.5(1) = 2 + 5 + 1.5 + 0.5 = 9%. If the policy rate is currently 6%, the rule judges policy three points too loose. Push inflation up one more point, to 6%, and the prescription rises by 1.5 points to 10.5%, so the implied real rate climbs from 9 - 5 = 4% to 10.5 - 6 = 4.5%.
The mistake students make with taylor rule
The common slip is dropping the standalone inflation term and computing i = r* + 0.5(inflation gap) + 0.5(output gap). That version lifts the nominal rate by only half a point per point of inflation, which lowers the real rate just as inflation is climbing, the reverse of what the rule intends. Inflation appears twice on purpose: once to keep the real rate anchored, once to answer the gap. The full response is 1.5 nominal points per point of inflation.
Taylor Rule questions
How do you calculate the Taylor rule?
The Taylor rule is calculated as the neutral real rate plus current inflation, plus 0.5 times the inflation gap, plus 0.5 times the output gap. With a 2% neutral real rate, 4% inflation, a 2% target and output 1% below potential, the prescribed rate is 2 + 4 + 0.5(2) + 0.5(-1) = 6.5%. Every input is expressed in percentage points and the answer is a nominal policy rate.
What is the Taylor principle?
The Taylor principle is the requirement that the policy rate rise by more than one point for every extra point of inflation. The rule satisfies it because inflation enters twice, producing a 1.5 point nominal move per point of inflation and therefore a higher real rate. A response of less than one for one would loosen policy in real terms as inflation rose, letting inflation feed on itself.
Do central banks actually follow the Taylor rule?
Central banks treat the Taylor rule as a benchmark rather than a binding instruction. Committees depart from it when they judge the neutral real rate has shifted, when financial stability is at stake, or when the output gap is measured too imprecisely to trust. Commentators still compute the prescription because it gives a concrete number to argue that a given policy rate is too high or too low.
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