Taylor rule
Encyclopedia
In economics
, a Taylor rule is a monetary-policy
rule that stipulates how much the central bank
should change the nominal interest rate
in response to changes in inflation
, output
, or other economic conditions. In particular, the rule stipulates that for each one-percent increase in inflation, the central bank should raise the nominal interest rate by more than one percentage point. This aspect of the rule is often called the Taylor principle.
The rule was first proposed by the U.S. economist John B. Taylor
in 1993.
It is intended to foster price stability and full employment by systematically reducing uncertainty and increasing the credibility of future actions by the central bank. It may also avoid the inefficiencies of time inconsistency from the exercise of discretionary policy
.
divergences of actual inflation rates from target inflation rates and of actual Gross Domestic Product
(GDP) from potential GDP:
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.
In this equation, both
and 
should be positive (as a rough rule of thumb, Taylor's 1993 paper proposed setting 
). That is, 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. 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.
, 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
, the sum of the two coefficients on 
in the equation above). Since the real interest rate
is (approximately) the nominal interest rate minus inflation, stipulating
implies that when inflation rises, the real interest rate
should be increased. The idea that the real interest rate should be raised to cool the economy when inflation increases (requiring the nominal interest rate to increase more than inflation does) has sometimes been called the Taylor principle.
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%.
macroeconomic models, insofar as the central bank keeps inflation stable, the degree of fluctuation in output will be optimized (Blanchard and Gali call this property the 'divine coincidence'). In this case, the central bank need not take fluctuations in the output gap into account when setting interest rates (that is, it may optimally set
.) On the other hand, other economists have proposed including additional terms in the Taylor rule to take into account financial conditions: for example, the interest rate might be raised when stock prices, housing prices, or interest rate spreads increase.
and Alan Greenspan
. 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 Bundesbank's policy did not officially target the inflation rate. This observation has been cited by Clarida
, Galí
, and Gertler
as a reason why inflation had remained under control and the economy had been relatively stable (the so-called 'Great Moderation') in most developed countries from the 1980s through the 2000s. However, according to Taylor, the rule was not followed in part of the 2000s, possibly leading to the housing bubble.
(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.
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...
, a Taylor rule is a monetary-policy
Monetary policy
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...
rule that stipulates how much the central bank
Central bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...
should change the nominal interest rate
Nominal interest rate
In finance and economics nominal interest rate or nominal rate of interest refers to the rate of interest before adjustment for inflation ; or, for interest rates "as stated" without adjustment for the full effect of compounding...
in response to changes in inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
, output
Gross domestic product
Gross domestic product refers to the market value of all final goods and services produced within a country in a given period. GDP per capita is often considered an indicator of a country's standard of living....
, or other economic conditions. In particular, the rule stipulates that for each one-percent increase in inflation, the central bank should raise the nominal interest rate by more than one percentage point. This aspect of the rule is often called the Taylor principle.
The rule was first proposed by the U.S. economist John B. Taylor
John B. Taylor
John Brian Taylor is the Mary and Robert Raymond Professor of Economics at Stanford University, and the George P. Shultz Senior Fellow in Economics at Stanford University's Hoover Institution....
in 1993.
It is intended to foster price stability and full employment by systematically reducing uncertainty and increasing the credibility of future actions by the central bank. It may also avoid the inefficiencies of time inconsistency from the exercise of discretionary policy
Discretionary policy
Discretionary policy is a term used to describe macroeconomic policy based on the ad hoc judgment of policymakers as opposed to policy set by predetermined rules...
.
As an equation
According to Taylor's original version of the rule, the nominal interest rate should respond todivergences of actual inflation rates from target inflation rates and of actual Gross Domestic Product
Gross domestic product
Gross domestic product refers to the market value of all final goods and services produced within a country in a given period. GDP per capita is often considered an indicator of a country's standard of living....
(GDP) from potential GDP:
In this equation,
is the target short-term nominal interest rateNominal interest rate
In finance and economics nominal interest rate or nominal rate of interest refers to the rate of interest before adjustment for inflation ; or, for interest rates "as stated" without adjustment for the full effect of compounding...
(e.g. the federal funds rate
Federal funds rate
In the United States, the federal funds rate is the interest rate at which depository institutions actively trade balances held at the Federal Reserve, called federal funds, with each other, usually overnight, on an uncollateralized basis. Institutions with surplus balances in their accounts lend...
in the US),
is the rate of inflationInflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
as measured by the GDP deflator
GDP deflator
In economics, the GDP deflator is a measure of the level of prices of all new, domestically produced, final goods and services in an economy...
,
is the desired rate of inflation, is the assumed equilibrium real interest rate, is the logarithm of real GDPGross domestic product
Gross domestic product refers to the market value of all final goods and services produced within a country in a given period. GDP per capita is often considered an indicator of a country's standard of living....
, and
is the logarithm of potential outputPotential output
In economics, potential output refers to the highest level of real Gross Domestic Product output that can be sustained over the long term. The existence of a limit is due to natural and institutional constraints...
, as determined by a linear trend.
In this equation, both
and should be positive (as a rough rule of thumb, Taylor's 1993 paper proposed setting ). That is, 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-employmentFull employment
In macroeconomics, full employment is a condition of the national economy, where all or nearly all persons willing and able to work at the prevailing wages and working conditions are able to do so....
level, in order to reduce inflationary pressure. It recommends a relatively low interest rate ("easy" monetary policy) in the opposite situation, to stimulate output. Sometimes monetary policy goals may conflict, as in the case of stagflation
Stagflation
In economics, stagflation is a situation in which the inflation rate is high and the economic growth rate slows down and unemployment remains steadily high...
, 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.
The Taylor principle
By specifying, the Taylor rule says that an increase in inflation by one percentage point should prompt the central bankCentral bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...
to raise the nominal interest rate
Nominal interest rate
In finance and economics nominal interest rate or nominal rate of interest refers to the rate of interest before adjustment for inflation ; or, for interest rates "as stated" without adjustment for the full effect of compounding...
by more than one percentage point (specifically, by
, the sum of the two coefficients on in the equation above). Since the real interest rateReal interest rate
The "real interest rate" is the rate of interest an investor expects to receive after allowing for inflation. It can be described more formally by the Fisher equation, which states that the real interest rate is approximately the nominal interest rate minus the inflation rate...
is (approximately) the nominal interest rate minus inflation, stipulating
implies that when inflation rises, the real interest rateReal interest rate
The "real interest rate" is the rate of interest an investor expects to receive after allowing for inflation. It can be described more formally by the Fisher equation, which states that the real interest rate is approximately the nominal interest rate minus the inflation rate...
should be increased. The idea that the real interest rate should be raised to cool the economy when inflation increases (requiring the nominal interest rate to increase more than inflation does) has sometimes been called the Taylor principle.
During an EconTalk
EconTalk
EconTalk is a weekly podcast hosted by professor Russell Roberts at George Mason University. Roberts interviews guests—often professional economists—on topics in economics....
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%.
Alternative versions of the rule
While the Taylor principle has proved very influential, there is more debate about the other terms that should enter into the rule. According to some simple New KeynesianNew Keynesian economics
New Keynesian economics is a school of contemporary macroeconomics that strives to provide microeconomic foundations for Keynesian economics. It developed partly as a response to criticisms of Keynesian macroeconomics by adherents of New Classical macroeconomics.Two main assumptions define the New...
macroeconomic models, insofar as the central bank keeps inflation stable, the degree of fluctuation in output will be optimized (Blanchard and Gali call this property the 'divine coincidence'). In this case, the central bank need not take fluctuations in the output gap into account when setting interest rates (that is, it may optimally set
.) On the other hand, other economists have proposed including additional terms in the Taylor rule to take into account financial conditions: for example, the interest rate might be raised when stock prices, housing prices, or interest rate spreads increase.Empirical relevance
Although the Federal Reserve does not explicitly follow the Taylor rule, many analysts have argued that the rule provides a fairly accurate summary of US monetary policy under Paul VolckerPaul Volcker
Paul Adolph Volcker, Jr. is an American economist. He was the Chairman of the Federal Reserve under United States Presidents Jimmy Carter and Ronald Reagan from August 1979 to August 1987. He is widely credited with ending the high levels of inflation seen in the United States in the 1970s and...
and Alan Greenspan
Alan Greenspan
Alan Greenspan is an American economist who served as Chairman of the Federal Reserve of the United States from 1987 to 2006. He currently works as a private advisor and provides consulting for firms through his company, Greenspan Associates LLC...
. 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
Germany
Germany , officially the Federal Republic of Germany , is a federal parliamentary republic in Europe. The country consists of 16 states while the capital and largest city is Berlin. Germany covers an area of 357,021 km2 and has a largely temperate seasonal climate...
where the Bundesbank's policy did not officially target the inflation rate. This observation has been cited by Clarida
Richard Clarida
Richard Clarida is an American economist, C. Lowell Harriss Professor of Economics and International Affairs at the School of International and Public Affairs at Columbia University and Global Strategic Advisor for PIMCO. He is notable for his contributions to dynamic stochastic general...
, Galí
Jordi Galí
Jordi Galí is a Spanish macroeconomist who is regarded as one of the main figures in New Keynesian macroeconomics today...
, and Gertler
Mark Gertler (economist)
Mark Lionel Gertler is an American economist and Henry and Lucy Moses Professor of Economics at New York University. A specialist in business cycles and monetary policy, he has been an associate and collaborator of Federal Reserve Chairman Ben Bernanke for more than 30 years. He is among the 20...
as a reason why inflation had remained under control and the economy had been relatively stable (the so-called 'Great Moderation') in most developed countries from the 1980s through the 2000s. However, according to Taylor, the rule was not followed in part of the 2000s, possibly leading to the housing bubble.
Criticisms
Athanasios OrphanidesAthanasios Orphanides
Athanasios Orphanides is a Cypriot economist who has been the Governor of the Central Bank of Cyprus since 3 May 2007 and a member of the Governing Council of the European Central Bank since 1 January 2008.Prior to his appointment as Governor, he served as Senior Adviser at the Board of...
(2003) claims that the Taylor rule can misguide policy makers since they face real-time data
Real-time data
Real-time data denotes information that is delivered immediately after collection. There is no delay in the timeliness of the information provided. Real-time data is often used for navigation or tracking....
. 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.
See also
- Monetary policyMonetary policyMonetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...
- Inflation targetingInflation targetingInflation targeting is an economic policy in which a central bank estimates and makes public a projected, or "target", inflation rate and then attempts to steer actual inflation towards the target through the use of interest rate changes and other monetary tools.Because interest rates and the...
- McCallum ruleMcCallum ruleIn monetary policy, the McCallum rule specifies a target for the monetary base which could be used by a central bank. The McCallum rule was proposed by Bennett T. McCallum at Carnegie Mellon University's Tepper School of Business. It is an alternative to the well known Taylor rule.-Rule:The rule...
- Monetary policy reaction functionMonetary policy reaction functionThe Monetary Policy Reaction Function is the upward-sloping relationship between the inflation rate and the unemployment rate. When the inflation rate rises, a central bank wishing to fight inflation will raise interest rates to reduce output and thus increase the unemployment rate.The MPRF is a...