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The Taylor rule is a
monetary policy Monetary policy is the policy adopted by the monetary authority of a nation to control either the interest rate payable for very short-term borrowing (borrowing by banks from each other to meet their short-term needs) or the money supply, often a ...
targeting rule. The rule was proposed in 1992 by American economist
John B. Taylor John Brian Taylor (born December 8, 1946) 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. He taught at Columbia Univer ...
for
central bank A central bank, reserve bank, or monetary authority is an institution that manages the currency and monetary policy of a country or monetary union, and oversees their commercial banking system. In contrast to a commercial bank, a central ba ...
s to use to stabilize economic activity by appropriately setting short-term
interest rate An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, th ...
s. The rule consider the
federal funds rate In the United States, the federal funds rate is the interest rate at which depository institutions (banks and credit unions) lend reserve balances to other depository institutions overnight on an uncollateralized basis. Reserve balances a ...
, the
price level The general price level is a hypothetical measure of overall prices for some set of goods and services (the consumer basket), in an economy or monetary union during a given interval (generally one day), normalized relative to some base set. ...
and changes in
real income Real income is the income of individuals or nations after adjusting for inflation. It is calculated by dividing nominal income by the price level. Real variables such as real income and real GDP are variables that are measured in physical units, ...
.John B. Taylor, Discretion versus policy rules in practice (1993), Stanford University, y, Stanford, CA 94905 The Taylor rule computes the optimal
federal funds rate In the United States, the federal funds rate is the interest rate at which depository institutions (banks and credit unions) lend reserve balances to other depository institutions overnight on an uncollateralized basis. Reserve balances a ...
based on the gap between the desired (targeted)
inflation rate In economics, inflation is an increase in the general price level of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reductio ...
and the actual inflation rate; and the
output gap The GDP gap or the output gap is the difference between actual GDP or actual output and potential GDP, in an attempt to identify the current economic position over the business cycle. The measure of output gap is largely used in macroeconomic po ...
between the actual and natural output level. According to Taylor, monetary policy is stabilizing when the
nominal interest rate In finance and economics, the nominal interest rate or nominal rate of interest is the rate of interest stated on a loan or investment, without any adjustments or fees. Examples of adjustments or fees # An adjustment for inflation(in contrast with ...
is higher/lower than the increase/decrease in
inflation In economics, inflation is an increase in the general price level of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reductio ...
. Thus the Taylor rule prescribes a relatively high interest rate when actual inflation is higher than the inflation target. In the
United States The United States of America (U.S.A. or USA), commonly known as the United States (U.S. or US) or America, is a country primarily located in North America. It consists of 50 states, a federal district, five major unincorporated territorie ...
, the
Federal Open Market Committee The Federal Open Market Committee (FOMC), a committee within the Federal Reserve System (the Fed), is charged under United States law with overseeing the nation's open market operations (e.g., the Fed's buying and selling of United States Treasur ...
controls monetary policy. The committee attempts to achieve an average inflation rate of 2% (with an equal likelihood of higher or lower inflation). The main advantage of a general targeting rule is that a central bank gains the discretion to apply multiple means to achieve the set target. The monetary policy of the
Federal Reserve The Federal Reserve System (often shortened to the Federal Reserve, or simply the Fed) is the central banking system of the United States of America. It was created on December 23, 1913, with the enactment of the Federal Reserve Act, after a ...
changed throughout the 20th century. The period between the 1960s and the 1970s is evaluated by Taylor and others as a period of poor monetary policy; the later years typically characterized as
stagflation In economics, stagflation or recession-inflation is a situation in which the inflation rate is high or increasing, the economic growth rate slows, and unemployment remains steadily high. It presents a dilemma for economic policy, since action ...
. The inflation rate was high and increasing, while interest rates were kept low. Since the mid-1970s monetary targets have been used in many countries as a means to target inflation. However, in the 2000s the actual interest rate in
advanced economies A developed country (or industrialized country, high-income country, more economically developed country (MEDC), advanced country) is a sovereign state that has a high quality of life, developed economy and advanced technological infrastruct ...
, notably in the US, was kept below the value suggested by the Taylor rule. The Taylor rule is typically contrasted with discretionary monetary policy, which relies on the personal views of the monetary policy authorities. The Taylor rule often faces criticism due to its complexity, the inaccuracy of the exogenous variables, and the limited number of factors it considers.


Equation

According to Taylor's original version of the rule, the
real Real may refer to: Currencies * Brazilian real (R$) * Central American Republic real * Mexican real * Portuguese real * Spanish real * Spanish colonial real Music Albums * ''Real'' (L'Arc-en-Ciel album) (2000) * ''Real'' (Bright album) (2010) ...
policy interest rate should respond to divergences of actual inflation rates from target inflation rates and of actual
Gross Domestic Product Gross domestic product (GDP) is a money, monetary Measurement in economics, measure of the market value of all the final goods and services produced and sold (not resold) in a specific time period by countries. Due to its complex and subjec ...
(GDP) from potential GDP: :i_t = \pi_t + r_t^* + a_\pi ( \pi_t - \pi_t^* ) + a_y ( y_t - \bar y_t ). In this equation, \,i_t\, is the target short-term
nominal Nominal may refer to: Linguistics and grammar * Nominal (linguistics), one of the parts of speech * Nominal, the adjectival form of "noun", as in "nominal agreement" (= "noun agreement") * Nominal sentence, a sentence without a finite verb * Nou ...
policy interest rate (e.g. the
federal funds rate In the United States, the federal funds rate is the interest rate at which depository institutions (banks and credit unions) lend reserve balances to other depository institutions overnight on an uncollateralized basis. Reserve balances a ...
in the US, the
Bank of England base rate A bank is a financial institution that accepts deposits from the public and creates a demand deposit while simultaneously making loans. Lending activities can be directly performed by the bank or indirectly through capital markets. Because ...
in the UK), \,\pi_t\, is the rate of
inflation In economics, inflation is an increase in the general price level of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reductio ...
as measured by the
GDP deflator In economics, the GDP deflator (implicit price deflator) is a measure of the money price of all new, domestically produced, final goods and services in an economy in a year relative to the real value of them. It can be used as a measure of the va ...
, \pi^*_t is the desired rate of inflation, r_t^* is the assumed natural/equilibrium interest rate, \,y_t\, is the
natural logarithm The natural logarithm of a number is its logarithm to the base of the mathematical constant , which is an irrational and transcendental number approximately equal to . The natural logarithm of is generally written as , , or sometimes, if ...
of actual
GDP Gross domestic product (GDP) is a monetary measure of the market value of all the final goods and services produced and sold (not resold) in a specific time period by countries. Due to its complex and subjective nature this measure is ofte ...
, and \bar y_t is the natural logarithm of
potential output In economics, potential output (also referred to as "natural gross domestic product") refers to the highest level of real gross domestic product (potential output) that can be sustained over the long term. Actual output happens in real life while ...
, as determined by a linear trend. y_t - \bar y_t is the
output gap The GDP gap or the output gap is the difference between actual GDP or actual output and potential GDP, in an attempt to identify the current economic position over the business cycle. The measure of output gap is largely used in macroeconomic po ...
. The \ln(1 + x) = x approximation is used here. Because of i_t - \pi_t = \mbox, : \begin \mbox &= \mbox \\ &+ a_ \times \mbox \\ &+ a_y \times \mbox \\ \end In this equation, both a_ and a_y should be positive (as a rough rule of thumb, Taylor's 1993 paper proposed setting a_=a_y=0.5). That is, the rule produces a relatively high real 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 real 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 with a substantial output gap. In such a situation, a Taylor rule specifies the relative weights given to reducing inflation versus increasing output.


Principle

By specifying a_>0, the Taylor rule says that an increase in inflation by one percentage point should prompt the
central bank A central bank, reserve bank, or monetary authority is an institution that manages the currency and monetary policy of a country or monetary union, and oversees their commercial banking system. In contrast to a commercial bank, a central ba ...
to raise the
nominal interest rate In finance and economics, the nominal interest rate or nominal rate of interest is the rate of interest stated on a loan or investment, without any adjustments or fees. Examples of adjustments or fees # An adjustment for inflation(in contrast with ...
by more than one percentage point (specifically, by 1+a_, the sum of the two coefficients on \pi_t in the equation). Since the
real interest rate The real interest rate is the rate of interest an investor, saver or lender receives (or 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 approx ...
is (approximately) the nominal interest rate minus inflation, stipulating a_>0 implies that when inflation rises, the
real interest rate The real interest rate is the rate of interest an investor, saver or lender receives (or 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 approx ...
should be increased. The idea that the nominal interest rate should be raised "more than one-for-one" to cool the economy when inflation increases (that is increasing the real interest rate) has been called the Taylor principle. The Taylor principle presumes a unique bounded equilibrium for inflation. If the Taylor principle is violated, then the inflation path may be unstable.


History

The concept of a policy rule emerged as part of the discussion on whether monetary policy should be based on intuition/discretion. The discourse began at the beginning of the 19th century. The first formal debate forum was launched in the 1920s by the US House Committee on Banking and Currency. In the hearing on the so-called Strong bill in 1923. the conflict in the views on the monetary policy clearly appeared. New York Fed Governor
Benjamin Strong Jr. Benjamin Strong Jr. (December 22, 1872 – October 16, 1928) was an American banker. He served as Governor of the Federal Reserve Bank of New York for 14 years until his death. He exerted great influence over the policy and actions of the entire ...
, supported by Professors
John R. Commons John Rogers Commons (October 13, 1862 – May 11, 1945) was an American institutional economist, Georgist, progressive and labor historian at the University of Wisconsin–Madison. Early years John R. Commons was born in Hollansburg, Ohio on ...
and
Irving Fisher Irving Fisher (February 27, 1867 – April 29, 1947) was an American economist, statistician, inventor, eugenicist and progressive social campaigner. He was one of the earliest American neoclassical economists, though his later work on debt def ...
, was concerned about the Fed's practices that attempted to ensure price stability. In his opinion, Federal Reserve policy regarding the price level could not guarantee long-term stability. After the death of the congressman, a political debate on changing the Fed's policy was suspended. The Fed was dominated at that time by Strong and his New York Reserve Bank. After the
Great Depression The Great Depression (19291939) was an economic shock that impacted most countries across the world. It was a period of economic depression that became evident after a major fall in stock prices in the United States. The economic contagio ...
hit the country, policies came under debate.
Irving Fisher Irving Fisher (February 27, 1867 – April 29, 1947) was an American economist, statistician, inventor, eugenicist and progressive social campaigner. He was one of the earliest American neoclassical economists, though his later work on debt def ...
opined, "this depression was almost wholly preventable and that it would have been prevented if Governor Strong had lived, who was conducting open-market operations with a view of bringing about stability". Later on, monetarists such as
Milton Friedman Milton Friedman (; July 31, 1912 – November 16, 2006) was an American economist and statistician who received the 1976 Nobel Memorial Prize in Economic Sciences for his research on consumption analysis, monetary history and theory and the ...
and
Anna Schwartz Anna Jacobson Schwartz (pronounced ; November 11, 1915 – June 21, 2012) was an American economist who worked at the National Bureau of Economic Research in New York City and a writer for ''The New York Times''. Paul Krugman has said that Schwar ...
agreed that high inflation could be avoided if the Fed managed the quantity of money more consistently. The 1960s recession in the US was accompanied by relatively high interest rates. After the
Bretton Woods agreement The Bretton Woods system of monetary management established the rules for commercial and financial relations among the United States, Canada, Western European countries, Australia, and Japan after the 1944 Bretton Woods Agreement. The Bretto ...
collapsed, policymakers focused on keeping interest rates low, which yielded the Great Inflation of 1970. Since the mid-1970s money supply targets have been used in many countries to address inflation targets. Many advanced economies, such as the US and the UK, made their policy rates broadly consistent with the Taylor rule in the period of the
Great Moderation The Great Moderation is a period in the United States of America starting from the mid-1980s until at least 2007 characterized by the reduction in the volatility of business cycle fluctuations in developed nations compared with the decades befor ...
between the mid-1980s and early 2000s. That period was characterized by limited inflation/stable prices. New Zealand went first, adopting an inflation target in 1990. The
Reserve Bank of New Zealand The Reserve Bank of New Zealand (RBNZ, mi, Te Pūtea Matua) is the central bank of New Zealand. It was established in 1934 and is constituted under the Reserve Bank of New Zealand Act 1989. The governor of the Reserve Bank is responsible for N ...
was reformed to prioritize price stability, gaining more independence at the same time. The
Bank of Canada The Bank of Canada (BoC; french: Banque du Canada) is a Crown corporation and Canada's central bank. Chartered in 1934 under the ''Bank of Canada Act'', it is responsible for formulating Canada's monetary policy,OECD. OECD Economic Surveys: Ca ...
(1991) and by 1994 the banks of Sweden, Finland, Australia, Spain, Israel and Chile were given the mandate to target inflation. Since the 2000s began the actual interest rate in advanced economies, especially in the US, was below that suggested by the Taylor rule. The deviation can be explained by the fact that central banks were supposed to mitigate the outcomes of financial busts, while intervening only given inflation expectations. Economic shocks were accompanied by lower rates.


Alternative versions

While the Taylor principle has proven influential, debate remains about what else the rule should incorporate. According to some
New Keynesian New Keynesian economics is a school of 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 macroec ...
macroeconomic models, insofar as the central bank keeps inflation stable, the degree of fluctuation in output will be optimized (economists
Olivier Blanchard Olivier Jean Blanchard (; born December 27, 1948) is a French economist and professor who is a senior fellow at the Peterson Institute for International Economics. He was the chief economist at the International Monetary Fund from September 1, 20 ...
and Jordi Gali call this property the ' divine coincidence'). In this case, the central bank does not need to take fluctuations in the output gap into account when setting interest rates (that is, it may optimally set a_y=0.) Other economists proposed adding terms to 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. Taylor offered a modified rule in 1999: that specfieid a_ = 0.5, a_y \ge 0.


Alternative theories

The solvency rule was presented by Emiliano Brancaccio after the 2008 financial crisis. The banker follows a rule aimed to control the economy's solvency . The inflation target and output gap are neglected, while the interest rate is conditional upon the solvency of workers and firms. The solvency rule was presented more as a benchmark than a mechanistic formula. The
McCallum rule In monetary policy, the McCallum rule specifies a target for the monetary base (M0) 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 ...
:was offered by economist Bennett T. McCallum at the end of the 20th-century. It targets the
nominal gross domestic product Gross domestic product (GDP) is a monetary measure of the market value of all the final goods and services produced and sold (not resold) in a specific time period by countries. Due to its complex and subjective nature this measure is ofte ...
. He proposed that the Fed stabilize nominal GDP. The McCallum rule uses precise financial data. Thus, it can overcome the problem of unobservable variables.
Market monetarism Market monetarism is a school of macroeconomic thought that advocates that central banks target the level of nominal income instead of inflation, unemployment, or other measures of economic activity, including in times of shocks such as the burs ...
extended the idea of NGDP targeting to include level targeting. (targeting a specific amount of growth per time period, and accelerating/decelerating growth to compensate for prior periods of weakness/strength). It also introduced the concept of targeting the forecast, such that policy is set to achieve the goal rather than merely to lean in one direction or the other. One proposed mechanism for assessing the impact of policy was to establish an NGDP
futures market A futures exchange or futures market is a central financial exchange where people can trade standardized futures contracts defined by the exchange. Futures contracts are derivatives contracts to buy or sell specific quantities of a commodity or fi ...
and use it to draw upon the insights of that market to direct policy.


Empirical relevance

Although the
Federal Reserve The Federal Reserve System (often shortened to the Federal Reserve, or simply the Fed) is the central banking system of the United States of America. It was created on December 23, 1913, with the enactment of the Federal Reserve Act, after a ...
does not follow the Taylor rule, many analysts have argued that it provides a fairly accurate explanation of US monetary policy under
Paul Volcker Paul Adolph Volcker Jr. (September 5, 1927 – December 8, 2019) was an American economist who served as the 12th chairman of the Federal Reserve from 1979 to 1987. During his tenure as chairman, Volcker was widely credited with having ended the ...
and
Alan Greenspan Alan Greenspan (born March 6, 1926) is an American economist who served as the 13th chairman of the Federal Reserve from 1987 to 2006. He works as a private adviser and provides consulting for firms through his company, Greenspan Associates LLC. ...
and other developed economies. 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 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 inflating the housing bubble. Some research has reported that households form expectations about the future path of interest rates, inflation, and unemployment in a way that is consistent with Taylor-type rules.


Limitations

The Taylor rule is debated in the discourse of the rules vs. discretion. Limitations of the Taylor rule include. * The 4 month period typically used is not accurate for tracking price changes, and is too long for setting interest rates. * The formula incorporates unobservable parameters that can be easily misevaluated. For example, the output-gap cannot be precisely estimated. * Forecasted variables such as the inflation and output gaps, are not accurate, depending on different scenarios of economic development. * Difficult to assess the state of the economy early enough to adjust policy. * The discretionary optimization that leads to stabilization bias and a lack of history dependence. * The rule does not consider financial parameters. * The rule not consider other policy instruments such as reserve funds adjustment or balance sheet policies. * The relationship between the interest rate and aggregate demand. Taylor highlighted that the rule should not be followed blindly: "…There will be episodes where monetary policy will need to be adjusted to deal with special factors."


Criticisms

Athanasios Orphanides Athanasios Orphanides (born 22 March 1962) is a Cypriot economist who served as Governor of the Central Bank of Cyprus between 3 May 2007 to 2 May 2012 and as a member of the Governing Council of the European Central Bank between 1 January 2008 ...
(2003) claimed that the Taylor rule can mislead policy makers who face
real-time data Real-time data (RTD) is 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. Such data is usually processed using real- ...
. He claimed that the Taylor rule matches the US funds rate less perfectly when accounting for informational limitations and that an activist policy following the Taylor rule would have resulted in inferior macroeconomic performance during the 1970s. In 2015, bond king Bill Gross said the Taylor rule "must now be discarded into the trash bin of history", in light of tepid GDP growth in the years after 2009. Gross believed that low interest rates were not the cure for decreased growth, but the source of the problem.


See also

*
Monetary policy Monetary policy is the policy adopted by the monetary authority of a nation to control either the interest rate payable for very short-term borrowing (borrowing by banks from each other to meet their short-term needs) or the money supply, often a ...
*
Monetary policy reaction function The monetary policy reaction function is a function that gives the value of a monetary policy tool that a central bank chooses, or is recommended to choose, in response to some indicator of economic conditions. Examples One such reaction functio ...
*
McCallum rule In monetary policy, the McCallum rule specifies a target for the monetary base (M0) 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 ...
*
Fisher effect In economics, the Fisher effect is the tendency for nominal interest rates to change to follow the inflation rate. It is named after the economist Irving Fisher, who first observed and explained this relationship. Fisher proposed that the real i ...
*
Market monetarism Market monetarism is a school of macroeconomic thought that advocates that central banks target the level of nominal income instead of inflation, unemployment, or other measures of economic activity, including in times of shocks such as the burs ...
*
Inflation targeting In macroeconomics, inflation targeting is a monetary policy where a central bank follows an explicit target for the inflation rate for the medium-term and announces this inflation target to the public. The assumption is that the best that moneta ...


References


External links


Resources from John Taylor's web site.Federal Reserve paper on the Taylor Rule.
{{DEFAULTSORT:Taylor Rule Federal Reserve System Monetary policy Monetary economics