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.

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.

• 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. 

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 development, 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 unemployment, eventually raising the neutral interest rate and vice versa.

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)

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 rate 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.

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

Example #1

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 becomes expansionary, as sudden long tax cuts, more infrastructural and technology-driven spending will raise aggregate demand, 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 GDP 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 run and stabilize inflation in the long run. In a nutshell, the Taylor rule rate directly and indirectly, affects Community Banks.

Taylor’s rule emphasizes that real rates play a crucial role while formulating monetary policy. 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 market 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.

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.

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