In 1993 economist John Taylor proposed the Taylor Rule, an equation designed to give central banks a guideline to set key interest rates so as to aim for steady, constant economic growth. This rule has since been very influential in the way central banks formulate and practice monetary policy. Understanding what the Taylor Rule is and how it works is crucial for understanding current monetary policy that aims to stabilize prices, ensure a healthy economy, and ensure maximum employment in many countries.
What is the Taylor Rule?
The Taylor Rule, named after its creator, is an equation that seeks to give central banks a framework for setting a federal funds rate. The Taylor Rule, or Taylor Principle, is mathematically expressed as:
Fed Funds rate = π + 0.5 x (Inflation Target – π) + (Output Gap – 2%)
where π is the inflation target.
In simple terms, the Taylor Rule seeks to set a federal funds rate equal to the inflation rate plus a “penalty term”, which is the gap between the target inflation rate and the actual inflation rate. This penalty term will vary according to the output gap, which is the difference between potential GDP and actual GDP.
Where Did the Taylor Rule Come From?
John Taylor, who is currently a senior fellow at the Hoover Institution at Stanford University, introduced his original idea in 1993 as part of a discussion of the goals of central bank policy. Taylor used historical data from the United States to propose an equation that would help central banks set an appropriate interest rate for their countries.
Since then, the Taylor Rule has become a basis for many central banks’ monetary policy decision-making.
How Is the Taylor Rule Converted into Practice?
When the Taylor Rule is applied, it is usually converted into practice through a few simple expectations.
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Inflation is the main aim of the Taylor Rule. Because it begins with a reference to the inflation rate, central banks seek to use it to maintain a steady level of inflation in the economy.
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Output levels should not vary too far away from potential output. Central banks want to maintain some stability in the output gap, so they will adjust the federal funds rate accordingly.
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The federal funds rate should remain within a certain range. The Taylor Rule is designed to provide a reference point rather than an exact rate, so central banks will normally set the rate between 0.5 and 1.5%.
What Other Monetary Policy Rules Are There?
Although the Taylor Rule has come to dominate central bank decision making, there are several other monetary policy rules employed by different banks.
The Baumol-Tobin Effect
The Baumol-Tobin Effect was proposed by William Baumol and James Tobin. Their rule recommends that if prices of goods and services are stable, then the real interest rate should equal the growth rate of productivity. This equation is expressed as:
Real Interest Rate = Productivity
Growth Rate
The Baumol-Tobin Effect is typically used to analyze the effects of changes in interest rates due to investment decisions, as well as to measure the effects of regional and global economic forces.
The Goodwin Rule
The Goodwin Rule was developed by Richard Goodwin, who in 1967 proposed an equation that would link the real rate of interest, unemployment rate, and the growth rate of per capita GDP. This rule is expressed as:
Real Interest Rate – Unemployment Rate = Growth Rate of Per Capita GDP
The Goodwin Rule is intended to tell central banks how to target full employment along with higher economic growth, while also attempting to keep inflation in check.
The Monetarist Rule
The Monetarist Rule was first proposed by Milton Friedman in the 1960s. This rule is based on the idea that central banks should focus on controlling the rate of growth of the money supply, rather than on affecting the economy through using adjustments of the federal funds rate. The equation for the Monetarist Rule is expressed as:
M2 = GDP x þα
where M2 is the Money Supply, GDP is the Gross Domestic Product, α is the target rate of growth (usually set to about 0.5%), and ß represents the averaging factor for the money supply, which is usually set to about 0.8.
Monetary policy plays a critical role in ensuring that prices remain stable and that economic growth is sustained. The Taylor Rule, proposed by economist John Taylor, is just one of several rules used by central banks to guide their decision-making process in setting interest rates. Even though the Taylor Rule dominates the decision-making of many central banks, other rules, such as the Baumol-Tobin Effect, the Goodwin Rule, and the Monetarist Rule, are also employed. Understanding the various rules and how they can be applied is essential to understanding how and why monetary policy decisions are made.
