Taylor Rule

Updated on April 9, 2024
Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What Is The Taylor Rule?

The Taylor rule helps the Central Bank set short-term interest rates when the inflation rate does not match the expected inflation rate. It suggests that when inflation increases above the target level or GDP growth are very high than expected, the Central Bank should raise its interest rates.

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Taylor Rule (wallstreetmojo.com)

It was named Taylor’s rule after John. B.Taylor played with Dale W. Henderson and Warwick Mckibbin in 1993. It is a term or a tool that Central Banks, which looks after a country’s commercial or governmental banking system, known as the Federal Reserve System, uses to appraise ideal short-term interest rates when the inflation rate does not match the expected inflation rate.

Key Takeaways

  • The Taylor rule assists the Central Bank in setting short-term interest rates if the inflation rate mismatches the expected inflation rate. 
  • It conveys that if inflation increases above the target level or GDP growth is higher than expected, the Central Bank may increase the interest rates. 
  • The Taylor rule emphasizes that actual interest rates play an important role in formulating monetary policy. Hence, the real interest rate shall cross equilibrium if inflation is above the target rate and the output is above potential. 
  • The bottom line of Taylor’s rule is that the Federal Reserve must increase the interest rate whenever inflation or employment is high. 

Taylor Rule Explained

The Taylor rule in economics states that the Federal Reserve should raise interest rates whenever inflation is high or employment is at its fullest level. On the contrary, interest rates should be decreased if employment levels and inflation rates are low.

The main idea behind the rule is that when inflation rises high interest rate will help in cooling down the economy. The Taylor rule interest rate is the best rate that addresses that gap between the actual inflation rate in the economy and desired inflation. This rate will help in stabilizing the country since after implementing the Taylor rule, the interest rate will be higher than the inflation, and the monetary policy will be effective.

Here, the important question arises relating to dynamic change in macroeconomic Macroeconomic Macroeconomics aims at studying aspects and phenomena important to the national economy and world economy at large like GDP, inflation, fiscal policies, monetary policies, unemployment rates.read moredevelopment, which will change the “neutral” value of the rate. The rate should neither be contractionary nor expansionary. Therefore, it would not tend to push unemployment above the target, and its effect should drive inflation above the mark.

If macroeconomic development leads to an increase in aggregate demand, it will increase inflation and decrease unemploymentUnemploymentUnemployment refers to a situation where individuals capable of working seek active opportunities for work but cannot find any for various reasons.read more, eventually raising the neutral interest rate and vice versa.

Financial Modeling & Valuation Courses Bundle (25+ Hours Video Series)

–>> If you want to learn Financial Modeling & Valuation professionally , then do check this ​Financial Modeling & Valuation Course Bundle​ (25+ hours of video tutorials with step by step McDonald’s Financial Model). Unlock the art of financial modeling and valuation with a comprehensive course covering McDonald’s forecast methodologies, advanced valuation techniques, and financial statements.

Formula

A simple formula is used to calculate a simple interest rate as per the Taylor rule in economics is as follows: –

Target Rate = Neutral Rate + 0.5 (Difference in GDP Rate) + 0.5 (Difference in Inflation Rate)

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Taylor Rule (wallstreetmojo.com)

How To Calculate?

As per the above formula, the Taylor rule interest rate states that:

Target Interest Rate = Neutral Rate +0.5 (Difference in GDP Rate) +0.5 (Difference in Inflation Rate)

Now, let us understand the terms used in the above formula: –

Target Rate: The target rate is the interest rate, and the Central Bank’s target is short-term. It is often related to the risk-free rateRisk-free RateA risk-free rate is the minimum rate of return expected on investment with zero risks by the investor. It is the government bonds of well-developed countries, either US treasury bonds or German government bonds. Although, it does not exist because every investment has a certain amount of risk.read more in the economy. It is also known as the federal funds rate or overnight rate/interbank lending rate between banks for a short period.

Neutral Rate: The current short-term interest rate is where the difference between the actual inflation rate, target inflation rate, expected GDP rate, and long-term GDP growth rate is zero.

The difference in GDP rates is (GDPe-GDPt)

where;

  • GDPe- The expected growth rate of GDP
  • GDPt- The target growth rate of GDP

The difference in Inflation rate is (Ie-It)

where;

  • Ie – Expected inflation rate
  • It- Target inflation rate

Before the difference in GDP and inflation gap, the multiplier can be any number, but Taylor suggested it be 0.5.

Examples

Below are examples of the Taylor rule equation to understand better.

Example #1

Here are some of the few examples which will help us understand the Taylor rule estimate better: –

Solution

a) If the household wants to save more due to increasing life expectancy, they tend to look for a longer period of retirement which eventually lowers aggregate demand at any given interest rate, and the neural rate falls.

b) Similarly, if the government’s fiscal policy Fiscal PolicyFiscal policy refers to government measures utilizing tax revenue and expenditure as a tool to attain economic objectives. read more becomes expansionary, as sudden long tax cuts, more infrastructural and technology-driven spending will raise aggregate demandAggregate DemandAggregate Demand is the overall demand for all the goods and the services in a country and is expressed as the total amount of money which is exchanged for such goods and services. It is a relationship between all the things which are bought within the country with their prices.read more, leading to a rising neutral rate.

Example #2

We will understand another practical industry example concerning Taylor rule estimate of banks: –

Taylor’s rule is a tool for Central Banks to determine their interest rate. We can use it to anticipate the interest rate 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 rates when inflation is above target, or

The GDPGDPGDP or Gross Domestic Product refers to the monetary measurement of the overall market value of the final output produced within a country over a period.read more growth rate is high, and lower its interest rate when inflation is below target or low. It can be a basic tool to stabilize the economy in the short runShort RunA Short Run in economics refers to a manufacturing planning period in which a business tries to meet the market demand by keeping one or more production inputs fixed while changing others.read more and stabilize inflation in the long run. In a nutshell, the Taylor rule rate directly and indirectly, affects Community Banks.

How To Use?

Taylor’s rule emphasizes that real rates play a crucial role while formulating monetary policy Monetary PolicyMonetary policy refers to the steps taken by a country’s central bank to control the money supply for economic stability. For example, policymakers manipulate money circulation for increasing employment, GDP, price stability by using tools such as interest rates, reserves, bonds, etc.read more. Therefore, the real interest rate will cross equilibrium when inflation is set above the target rate, and output is above potential. One can use it in government, banks, etc.

This Taylor rule rate proves to be a benchmark for policymakers. It helps policy set in an economy through a systematic approach over time, which eventually helps produce good outcomes on average.

This rule also helps participants in the financial marketThe Financial MarketThe term "financial market" refers to the marketplace where activities such as the creation and trading of various financial assets such as bonds, stocks, commodities, currencies, and derivatives take place. It provides a platform for sellers and buyers to interact and trade at a price determined by market forces.read more forms a baseline for their expectations regarding the future course of monetary policy.

With the help of this rule, the Central Bank can easily communicate with the public, which is an important transmission mechanism of monetary policy.

Frequently Asked Questions (FAQs)

What is Taylor’s rule in monetary policy?

The Taylor rule conveys that the Federal Reserve must increase the rates if inflation exceeds the target or if Gross Domestic Product (GDP) development is high and above potential. Conversely, it also mentions that the Fed must lower interest rates if the inflation is below the target level or if the GDP growth is gradual and lower than the potential.

What is the Taylor rule criticism?

The Taylor rule typically contrasts with the discretionary monetary policy, which depends on the monetary policy authorities’ personal opinions. However, it faces criticism due to its exogenous variables’ inaccuracy and intricacy and considers the restricted factors.

What are the benefits of Taylor’s rule?

The Taylor rule accommodates the equilibrium rate depending on the difference in inflation and the real GDP growth from the targets of the Central Bank. The inflation and growth targets jump increases the policy rate under the Taylor rule while the deficit diminishes it.

Recommended Articles

This article is a guide to what is the Taylor Rule Formula. We explain it with formula, example, how to calculate it and how to use it, and a downloadable Excel template.

Reader Interactions

Leave a Reply

Your email address will not be published. Required fields are marked *