Taylor rule

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Taylor rule

Describes how a central bank should adjust short-term interest rates (e.g. the Federal Funds rate) in response to inflation or output gaps. According to the rule, the interest rate should be increased if inflation rises above the target rate of inflation or if real GDP rises above trend GDP (increasing interest rates would squeeze credit supply to decrease demand and bring prices under control.) On the other hand, if inflation or real GDP fall below their target values, interest rates should be decreased. Proposed by economist John B. Taylor in 1993.
Copyright © 2012, Campbell R. Harvey. All Rights Reserved.

Taylors Rule

A general rule for central banks when deciding interest rates. The rule states that interest rates should be increased in times of high inflation and when employment is higher than full employment, and should be decreased in periods of low inflations and higher unemployment. The rule states that following these principles will encourage growth while discouraging inflation. The Federal Reserve follows this rule implicitly, even though it does not explicitly endorse it.
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Taylor rule

a specific policy rule for fixing US INTEREST RATES proposed by the American economist John Taylor. Taylor argued that when real GROSS DOMESTIC PRODUCT (GDP) equals POTENTIAL GROSS DOMESTIC PRODUCT and INFLATION equals its target rate of 2%, then the Federal Fund Rate should be 4% (that is, a 2% real interest rate). If real GDP rises 1% above potential

GDP, then the Federal Fund Rate should be raised by 0.5%. If inflation rises 1% above its target rate of 2%, then the Federal Fund Rate should be raised 0.5%. This rule has been suggested as one that could be adopted by other central banks, such as the EUROPEAN CENTRAL BANK and the MONETARY POLICY COMMITTEE of the Bank of England, for setting official interest rates.

However, the rule does embody an arbitrary 2% inflation target rather than, say, 3% or 4%, and it may need to be amended to embody alternative inflation targets at different times or by different central banks. The advantages of having such an explicit interest rate rule is that its very transparency can create better conditions for business decisions and can help to shape business people's and consumers’ expectations.

Collins Dictionary of Economics, 4th ed. © C. Pass, B. Lowes, L. Davies 2005
References in periodicals archive ?
We (8) show that the Taylor-rule model, when expressed as a present value relationship, has a modest positive correlation with the actual real dollar/DM rate over the 1979-98 period.
(12) As noted above, Taylor-rule models imply that a country's currency will appreciate when there is news of higher inflation.
In particular, I use inflation and output data to estimate a baseline Taylor-rule specification for policy and test whether the bias statement provides any additional information for forecasting changes in the FOMC's Federal funds rate target.
The information content in the bias statement has been a statistically significant factor for predicting changes in the funds rate target over the sample period, even after controlling for responses to policy variables in the Taylor-rule equation.
Specifically, the second example imposes a Taylor-rule restriction onto the forecasts from a VAR model of output, inflation and interest rates.
That is, the Taylor-rule appears to describe the behavior of the variables more accurately than does the unrestricted VAR model.
On the other hand, Orphanides (2000) used real-time data to estimate a Taylor-rule equation and compared these estimates with Taylor-rule estimates based on revised data.
How then can one explain the increase over time in Taylor-rule regressions of the estimated value of [g.sub.[pi]], the parameter that is supposed to capture the response of the central bank to inflation?
Taylor-rule recommendations in a given quarter are based on the output gap in the same quarter and on inflation over the four quarters ending in the same quarter.
Its plots show that the Taylor-rule gap was especially large--200 basis points or more--from mid-2003 to mid-2005.
One is its emphasis on the difficulty of measuring the "output gap" variable that appears m price-adjustment and Taylor-rule equations, that is, the percentage difference between current output and its "potential" or "natural-rate" value.
Arguably, then, the clear departure of the Fed funds rate from the Taylor-rule during those years might plausibly be accounted for in terms of an adjustment by the Greenspan Fed for an exceedingly low natural rate.