Taylor Rule
Quick Definition
A formula that suggests how central banks should adjust interest rates based on deviations of inflation and output from their targets.
Key Takeaways
- Prescribes interest rates based on inflation gap and output gap
- Formula: Rate = Neutral Rate + 0.5(Inflation Gap) + 0.5(Output Gap)
- Used as a benchmark, not mechanically followed by central banks
- Deviations from the rule indicate whether policy is too loose or tight
What Is Taylor Rule?
The Taylor Rule, proposed by economist John Taylor in 1993, is a monetary policy guideline that prescribes how a central bank should set its benchmark interest rate based on two key factors: the gap between actual and target inflation, and the gap between actual and potential GDP (the output gap). The formula is: Federal Funds Rate = Neutral Rate + 0.5 × (Inflation − Target Inflation) + 0.5 × (Output Gap). If inflation exceeds the target, the rule recommends raising rates; if output falls below potential, it recommends lowering rates. While no central bank mechanically follows the Taylor Rule, it serves as a useful benchmark for evaluating whether monetary policy is too tight, too loose, or appropriately calibrated. Deviations from the Taylor Rule often spark debate about central bank policy choices.
Taylor Rule Example
- 1In 2021-2022, the Taylor Rule suggested the Fed funds rate should be 7-9%, far above the actual rate of 0-0.25%, indicating policy was very loose.
- 2The original Taylor Rule with 2% neutral rate and 2% inflation target would set rates at: 2% + 0.5(Inflation-2%) + 0.5(Output Gap).
- 3Fed Chair Ben Bernanke argued the original Taylor Rule was too rigid and that modified versions better fit modern conditions.
Related Terms
Neutral Interest Rate (r*)
The theoretical interest rate that neither stimulates nor restricts economic growth, keeping the economy at full employment with stable inflation.
Inflation Target
A publicly announced goal for the rate of inflation that a central bank aims to achieve, typically around 2% in advanced economies.
Output Gap
The difference between an economy's actual GDP and its potential GDP, indicating whether the economy is operating above or below its sustainable capacity.
Federal Funds Rate
The interest rate at which banks lend reserve balances to each other overnight, set as a target range by the Federal Reserve.
Monetary Policy
Actions by a central bank to manage the money supply and interest rates to achieve macroeconomic objectives like stable prices and full employment.
GDP (Gross Domestic Product)
The total monetary value of all finished goods and services produced within a country's borders in a specific time period.
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