Taylor Rule | Money Definitions

The Taylor Rule[1] is a formula named for its inventor, Stanford economist John Taylor that helps central banks set short term interest rates. The Federal Reserve Bank of San Francisco says, "real" short-term interest rates (the interest rate adjusted for inflation) should be determined according to three factors:

(where actual inflation is relative to the targeted level that the Fed wishes to achieve
how far economic activity is above or below its "full employment" level, and
what the level of the short-term interest rate is that would be consistent with full employment.

The rule "recommends" higher interest rates (tight money) when inflation is above its target or when the economy is above its full employment level.

The rule “recommends” lower interest rates ("easy" money) when inflation is below its target or when the economy is below its full employment level..

Sometimes these goals are in conflict: for example, today inflation is well above its target while the economy is below full employment. In this case, the rule provides guidance to Fed policy makers on how to balance these competing considerations when they meet to set rates.

From Wikipedia: $i_t = \pi_t + r_t^* + a_\pi ( \pi_t - \pi_t^* ) + a_y ( y_t - \bar y_t )$

In this equation, it is the target short-term nominal interest rate (e.g. the federal funds rate in the US), πt is the rate of inflation as measured by the GDP deflator, $\pi^*_t$ is the desired rate of inflation, $r_t^*$ is the assumed equilibrium real interest rate, yt is the logarithm of real GDP, and $\bar y_t$ is the logarithm of potential output, as determined by a linear trend (Taylor, 1993).

[1] Taylor, John B. 1993. "Discretion Versus Policy Rules in Practice," http://www.stanford.edu/~johntayl/Papers/Discretion.PDF

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