The Taylor rule was first proposed by economist John B. Taylor in 1993 to provide guidance to the U.S. Federal Reserve* and other central banks for setting short-term interest rates based on economic conditions. John Taylor proposes how Central Banks should alter interest rates in response to changes in economic conditions mainly inflation and economic growth or the unemployment rate.
The Taylor rule recommends ‘tight monetary policy’ (that is a relatively high interest rate) when inflation is above Central Bank’s target or when the economy is above its full employment level. In the contrasting situation like when the inflation is below the targeted level, the rule recommends ‘Easy Monetary Policy’ (that is a relatively low interest rate) adjusted for low inflation and unemployment rate. According to Taylor rule, the interest rate adjusted for inflation should be determined by following three factors:
- Central Bank’s targeted level compared to actual inflation level.
- Full employment compared to actual employment level
- The short term interest rate should be consistent with fostering full employment.
Dr. Ben S. Bernanke, a Distinguished Fellow in residence with the Economic Studies Program at the Brookings Institution, (as well as former U.S. Federal Reserve Chair (2006-2014) in his article of 28th April 2015 wrote that Taylor rule is a simple mathematical equation which can be described as under.
r = p +0 .5y +0.5(p – 2) + 2,
r = federal funds rate
p= the rate of inflation
y= the percent deviation of real GDP from the central bank’s target.
*Federal Reserve is the central banking system of the United States. Bernanke explains that the variable y in the Taylor rule can be interpreted as the excess of actual GDP over potential output, also known as the output gap.