What is Taylor Rule?
Taylor rule helps the Central bank to set short term interest rates when the inflation rate doesn’t match with the expected inflation rate and suggests that when there is an increase in inflation above the target level or GDP growth is too high that expected, then the Central Bank should raise its interest rates.
It was named as Taylor’s Rule as it was given by John. B.Taylor with Dale W Henderson and Warwick Mckibbin in the year 1993. It is a term or a tool that is prominently used by Central Banks to appraise ideal short term interest rates when the inflation rate doesn’t match with the expected inflation rate.
Central Bank is a national bank that looks after a country’s commercial or Governmental Banking system known as the Federal Reserve System.
Taylor Rule Formula
A simple formula which is used to calculate simple Interest rate as per Taylor’s Rule:
Target Interest Rate = Neutral Rate +0.5 (Difference in GDP Rate) +0.5 (Difference in Inflation Rate)
Now let’s understand the term used in the above formula:
Target Rate: Target rate is the interest rate which the Central Bank target is Short term. It is often related to the Risk-Free rate in the economy. It is also known as Fed fund rates or overnight rate/Interbank lending rate between banks for short term period of time.
Neutral Rate: It is the current short term Interest Rate where the difference between actual Inflation Rate and target inflation rate and expected GDP rate and long term GDP growth rate are both nils.
The difference in GDP rates is (GDPe-GDPt)
- GDPe- an Expected growth rate of GPP
- GDPt- the Target growth rate of GDP
The difference in Inflation rate is (Ie-It)
- Ie- Expected Inflation rate
- It- Target Inflation rate
The Multiplier before the difference in GDP and Inflation gap can be any number but Taylor’s suggested it to be 0.5.
Here the important question that arises relates to dynamic change in macroeconomic development which will change the “neutral” value of rate. The rate should neither be contractionary nor expansionary, meaning thereby it would not tend to push unemployment above target and not its effect should drive inflation above target.
If macroeconomic development leads to an increase in aggregate demand it will increase the inflation and lower the unemployment, eventually rise in neutral rate of interest and vice versa.
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Examples of Taylor Rule Formula (with Excel Template)
Given below are the examples of the Taylor Rule Equation to understand it better.
Here are some of the few examples which will help us better understanding:
a) Just in case if the household wants to save more due to increasing life expectancy, they tend to look for a longer period of retirement which eventually lower aggregate demand at any given rate of interest and the neural rate falls.
b) In a similar manner if due to the fiscal policy of govt. becomes expansionary, as sudden long tax cuts, more infrastructural and technology-driven spending will raise aggregate demand leading to rising in neutral rate.
Some of the variables that we will use and by putting the said variable in the above formula, we shall be able to calculate our Target Rate:
- Target Inflation Rate=1%
- Long Term GDP Growth rate= 3 %
- An annual GDP growth rate of 3.5 % for the first 2 months
- Expected rate of Inflation=2%
Calculation of Target Interest Rate is as follows –
- = 2%+ 0.5 (3.5%-3%) + 0.5 (2%-1%)
Target Interest Rate will be –
- Target Interest Rate = 2.75 %
Now when the target rate gets increased by .75 % is because of the increase in Inflation rate and anticipated growth in GDP so that the economy can be regulated better.
Suppose Mr Noah and Mr Kite are working in the finance department in a renowned organization of fitness and gym industry and playing the role of a financial analyst. They were assigned the work to achieve specialization in debt securities research in one of its departments where it’s going to invest a larger sum say GYM Department. Now in a certain year say 20XX, the Economy started to grow at its long term growth rate and inflation rate set at its target rate of 3%., Also Federal Reserve had set its short-term interest rate of 5 %. Now on 05.02.20XX suppose meeting of Federal Open Market Committee (FOMC) is going to held within the week to decide whether the interest rate be increased or not? Mr Noah is now looking for certain hints to anticipate the decision and likely effect of a decision taken by FOMC. So he approached Mr Kite with the requisite information here:
Expected rate of Inflation 4.00% Long term growth rate of GDP 2.8% Annual growth rate of GDP in first 2 months which will continue 2.00% Now you want to know about the outcome of FOMC meeting:
Use the below-given data for calculation of target short term rate
Calculation of target short term rate is as follows-
- = 5%+ 0.5 (2%-2.8%) + 0.5(5%-3%)
Target Short Term Rate will be –
- Target Short Term Rate =5.60%
Based on this new data FOMC will be going to revise the short term interest rate by 1.25 % to the new target rate of 5.25 %. The expected growth rate of GDP and the Expected rate of inflation corresponding to target has made it necessary to increase the interest rate so that balance in an economy is achieved and it can be cool down.
Another Practical Industry Example will be understood with respect to banks:
Taylor’s Rule is a tool for Central Banks to determine its Interest rate. It can be used to anticipate the Interest rate should be based on the following inputs:
1) Potential Output v/s Real output
2) Target inflation v/s Actual Inflation
It simply means that Banks should raise short term interest rate when inflation is above target or
GDP growth rate is high and it should lower its interest rate when inflation is below target or low GDP growth rate. This can be a basic tool to stabilize the economy in the short-run and stabilizing inflation in Long Run. In nutshell, Taylor Rule has a direct as well as an indirect effect on Community Banks.
Relevance and Use
Taylor’s Rule emphasizes that while formulating Monetary Policy, Real rates play crucial roles, meaning thereby real Interest rate will cross equilibrium when the Inflation rate is set above target rate and output is above potential. It can be used in the Monetary Policy of Government, Banks, etc.
This rule Proves to be a benchmark for Policy Makers where it helps policy set in an economy through a systematic approach over time which eventually helps to produce good outcomes on an average.
This rule also helps participants in the financial market to form a baseline for their expectations regarding the future course of monetary policy.
With the help of this rule, Central Bank can easily communicate with the Public which is an important transmission mechanism of monetary policy.
In nutshell, the crux of Taylor’s rule lies in the fact that whenever inflation is high or employment is at its fullest level then-Federal Reserve should raise interest rates. On the Contrary, if employment levels, as well as inflation rate, are low, Interest rates should be decreased.
This has been a guide to Taylor Rule Formula. Here we discuss how to calculate target short term rate & target interest rate using the Taylor Rule formula along with examples and downloadable excel template.