The Taylor rule is an interest rate prediction model invented by the famous economist John Taylor in 1992, and it was summarized in his 1993 study “Discretion in Practice and Policy Rules”. It shows how the central bank should change interest rates in response to inflation and other economic conditions.

The Taylor Rule recommends that when inflation is higher than the target or GDP growth is too high and higher than potential, the Fed should raise interest rates. It also shows that when inflation is below the target level or GDP growth is too slow and below the potential level, the Fed should lower interest rates.

Taylor Rule: Calculating Monetary Policy

## Taylor rule background

I = R * + PI + 0. 5 (PI − PI *) + 0. 5 (Y − Y ∗) where: I = nominal federal funds rate R ∗ = actual federal funds rate (usually 2%) PI = inflation rate PI ∗ = target inflation rate Y = logarithm of actual output Y ∗ = Logarithmic output of potential begin{aligned} &I = R ^ {*} + PI + {0.5} left (PI-PI ^ * right) + {0.5} left (Y-Y ^ * right) \ &textbf {where:}\ &I = text{nominal federal funds rate} \ &R ^ * = text{actual federal funds rate (usually 2%)} \ π = text{currency Inflation rate} \ π ^ * = text{target inflation rate} \ &Y = text{logarithm of actual output} \ &Y ^ * = text{logarithm of potential output} \ end {Align}

A generation=resistance＊+phosphorusA generation+.5(phosphorusA generation–phosphorusA generation＊)+.5(Yes–Yes＊)Where:A generation=Nominal federal funds rateresistance＊=The actual federal funds rate (usually 2%)phosphorusA generation=Inflation ratephosphorusA generation＊=Target inflation rateYes=Logarithm of actual outputYes＊=Logarithm of potential output

Taylor operated on credible assumptions in the early 1990s that the Fed determined future interest rates based on the rational expectations theory of macroeconomics. This is a retrospective model that assumes that if workers, consumers, and companies have positive expectations about the future of the economy, then interest rates do not need to be adjusted.

Taylor pointed out that the problem with this model is not only that it looks backwards, but it also does not take into account the long-term economic prospects. This situation led to the Taylor rule.

Since its inception, the Taylor Rule has not only been used as an indicator to measure interest rates, inflation, and output levels, but also as a guide to measure the appropriate level of money supply.

## Taylor rule formula

The product of Taylor’s rule is three numbers: interest rate, inflation rate, and GDP rate, all of which are based on equilibrium interest rates to measure the appropriate balance of interest rates predicted by the monetary authorities.

This formula shows that the difference between the nominal interest rate and the real interest rate is inflation. The real interest rate explains inflation, while the nominal interest rate does not. In order to compare the inflation rate, we must look at the factors that drive it.

## Three factors that cause inflation

Prices and inflation are driven by three factors: consumer price index (CPI), producer price and employment index. Most modern countries treat the consumer price index as a whole, rather than the core CPI. Since the core CPI does not include food and energy prices, this method allows observers to look at the overall situation of the economy from the perspective of prices and inflation.

Price increases mean higher inflation, so Taylor recommends taking one year (or four quarters) of inflation into account to get a comprehensive picture.

He suggested that the real interest rate should be 1.5 times the inflation rate. This is based on the assumption of an equilibrium interest rate, which takes into account the actual inflation rate and the expected inflation rate. Taylor calls this equilibrium, a steady state of 2%, which equals a ratio of approximately 2%. But this is only part of the equation-the output must also be taken into account.

To properly measure inflation and price levels, apply moving averages of various price levels to determine trends and eliminate fluctuations. Perform the same function on the monthly interest rate chart. Determine trends based on the federal funds rate.

## Determine total economic output

The total output of an economy can be determined by productivity, labor force participation, and employment changes. For the Taylor rule calculation, we compare the actual output with the potential output.

The Taylor rule treats GDP in terms of actual and nominal GDP, or what Taylor calls actual GDP and trend GDP. It takes into account the GDP deflator, which measures the price of all domestically produced goods. We do this by dividing nominal GDP by real GDP and multiplying this number by 100.

The answer is the actual GDP figure. We reduce the nominal GDP to a real number to fully measure the total output of an economy.

When the inflation rate reaches the target and GDP is growing at its potential, interest rates are considered neutral. The model aims to stabilize the economy in the short term and stabilize inflation in the long term.

## Taylor rule and asset bubbles

Some people believe that the central bank should (at least partly) be responsible for the 2007-2008 housing crisis. They asserted that after the dot-com bubble and in the years before the real estate market crash in 2008, interest rates have remained too low.

This is the cause of asset bubbles, so interest rates must eventually be raised to balance inflation and output levels. Another problem with asset bubbles is that the level of money supply is much higher than the level needed to balance an economy suffering from inflation and output imbalances.

If the central bank follows the Taylor rule during this time, it means that interest rates should be higher and the bubble may be smaller because fewer people will be incentivized to buy houses.

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