Taylor Rule

John Taylor proposed the following rule designed to guide monetary policy:

i = r* + pi + 0.5 ( pi - pi*) + 0.5 ( y - y*)

where i is the nominal federal funds rate, r* is the "natural" real federal funds rate (often taken to be 2%), pi is the rate of inflation, pi* is the target inflation rate (for example, 2%), y is the logarithm of real output, and y* is the logarithm of potential output.

The two basic ideas here are to raise the federal funds rate to one-half the extent that inflation exceeds its target and to lower the federal funds rate to one-half of the percentage that real output falls below its potential. Implicit in this formulation is that a reasonable rule of thumb applied consistently over time is more likely to achieve a good outcome than is aggressive manipulation of monetary policy. It is widely believed that central banks have paid close attention to variations on this Taylor Rule in recent years.

See also: Federal Funds Rate and Discretion versus policy rules in practice, John B. Taylor, Carnegie-Rochester Conference Series on Public Policy 39 (1993), 195-214.

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