The Taylor rule is a formula developed by Stanford economist John Taylor. It was designed to provide monetary policy guidance for the Federal Reserve. The formula suggests short-term interest rates depending on changing economic conditions, in order to keep the economy stable in the short term, and minimize inflation over the long term.
The rule stipulates how much a central bank should change the nominal interest rate (real rate plus inflation) in response to changes in inflation, output, or other economic conditions. In particular, the rule stipulates that for each one-percent increase in inflation, the central bank should raise the nominal interest rate by more than one percentage point.
Professor John Taylor
Stanford University Professor John Taylor is the creator of the Taylor Rule, a monetary policy instrument developed to promote stable economic growth and limit short-run economic disruption related to inflation.
The factors that the Taylor rule suggests taking into account when setting inflation-adjusted short-term interest rates are:
- the level of actual inflation relative to the target,
- how far economic activity is above or below its "full employment" level, and
- what the level of the short-term interest rate is that would be consistent with full employment.
The Taylor rule advocates setting interest rates relatively high (contractionary policy) when inflation is high or when the employment rate exceeds the economy's full employment level. Expansionary policies with low interest rates are recommended by the Taylor rule in times when the economy is slow (i.e. unemployment is high, or inflation is low).
The Taylor rule doesn't always provide an easy answer. For example, in times of stagflation, inflation may be high while unemployment is also high. However, the Taylor rule can still provide a handy "rule of thumb" to policy makers on how to balance these conflicting issues when setting the interest rates.
The Taylor rule fairly accurately demonstrates how monetary policy has been conducted under recent leaders of the Federal Reserve, such as Volker and Greenspan. However, the Federal Reserve does not follow the Taylor rule as an explicit policy.