Taylor rule
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The Taylor rule is a modern monetary policy rule proposed by economist John B. Taylor that stipulates how much the central bank should change the nominal interest rate in response to divergences of actual GDP from potential GDP and divergences of actual rates of inflation from a target rate of inflation.[1] The rule can be written as follows:
In this equation, it is the target short-term nominal interest rate (e.g. the federal funds rate in the US), πt is the rate of inflation as measured by the GDP deflator, 
is the desired rate of inflation, 
is the assumed equilibrium real interest rate, yt is the logarithm of real GDP, and 
is the logarithm of potential output, as determined by a linear trend (Taylor, 1993).
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[edit] Interpretation
According to the rule, both aπ and ay should be positive (as a rough rule of thumb, Taylor's 1993 paper proposed setting aπ = ay = 0.5). That is, the rule "recommends" a relatively high interest rate (a "tight" monetary policy) when inflation is above its target or when the economy is above its full employment level, and a relatively low interest rate ("easy" monetary policy) in the opposite situations. Sometimes these goals are in conflict: inflation may be above its target while the economy is below full employment (as in the case of stagflation). In such situations, the rule provides guidance to policy makers on how to balance these competing considerations in setting an appropriate level for the interest rate.
A crucial detail is that by setting aπ > 0, the Taylor rule says that the nominal interest rate should be increased by more than one percentage point for each percentage point increase in inflation. In other words, since the real interest rate is (approximately) the nominal interest rate minus inflation, stipulating aπ > 0 is equivalent to saying that when inflation rises, the real interest rate should be increased.
Although the Fed does not explicitly follow the rule, many analyses show that the rule does a fairly accurate job of describing how US monetary policy actually has been conducted during the past decade under Alan Greenspan.[2][3] 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 central bank's policy did not officially target the inflation rate.[4][5] This observation has been cited by many economists as a reason why inflation has remained under control and the economy has been relatively stable in most developed countries since the 1980s.
[edit] Critique
Orphanides (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.[6]
[edit] See also
[edit] References
- ^ Taylor, John B. (1993): Discretion versus Policy Rules in Practice, Carnegie-Rochester Conference Series on Public Policy 39, 195-214.
- ^ Clarida, Richard; Mark Gertler; and Jordi Galí (2000), 'Monetary policy rules and macroeconomic stability: theory and some evidence.' Quarterly Journal of Economics 115. pp. 147-180.
- ^ Lowenstein, Roger (2008-01-20), “The Education of Ben Bernanke”, The New York Times, <http://www.nytimes.com/2008/01/20/magazine/20Ben-Bernanke-t.html>
- ^ Bernanke, Ben, and Ilian Mihov (1997), 'What does the Bundesbank target?' European Economic Review 41 (6), pp. 1025-53.
- ^ Clarida, Richard; Mark Gertler; and Jordi Galí (1998), 'Monetary policy rules in practice: some international evidence.' European Economic Review 42 (6), pp. 1033-67.
- ^ Orphanides, A. (2003): The quest for prosperity without inflation, Journal of Monetary Economics 50, p. 633-663.
[edit] External links
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