The Taylor Rule in Economics: Definition, Formula & Example

Coming up next: What is Economics? - Definition, History, Timeline & Importance

You're on a roll. Keep up the good work!

Replay
Your next lesson will play in 10 seconds
• 0:05 Definition of the Taylor Rule
• 1:01 Key Factors of the Taylor Rule
• 1:41 Formula for the Taylor Rule
• 2:32 How Does the Formula Work?
• 3:27 Benefits & Limits of…
• 4:23 Lesson Summary

Want to watch this again later?

Timeline
Autoplay
Autoplay
Speed

Recommended Lessons and Courses for You

Lesson Transcript
Instructor: Jennifer Francis

Jennifer has a Masters Degree in Business Administration and pursuing a Doctoral degree. She has 14 years of experience as a classroom teacher, and several years in both retail and manufacturing.

In this lesson, you'll find out how central banks use the Taylor rule in economics. You'll have the chance to become familiar with some key definitions, learn how to use a formula to apply the Taylor rule, and try your hand at a real-life sample calculation.

Definition of the Taylor Rule

The Taylor rule, created by John Taylor, an economist at Stanford University, is a principle used in the management of interest rates. For example, central banks use the rule to make estimates of ideal short-term interest rates when there is an inflation rate that does not match the expected inflation rate. A central bank is a national bank that oversees a country's commercial or governmental banking system, such as the Federal Reserve System. It may also distribute currency or oversee monetary policies.

It is also useful when the expected gross domestic product (GDP) is different from the actual GDP growth in the long term. The GDP is the total cost of products and services delivered by an individual country in one year.

The main aim of the Taylor rule is to bring stability to the economy for the near term, while still sustaining long-term expansion. Let's take a look at some of its guiding principles.

Key Factors of the Taylor Rule

The Taylor rule is based upon three factors:

1. The targeted rate of inflation in relation to the actual inflation rates
2. The real levels of employment, as opposed to full employment
3. An interest rate consistent with full employment in the short term

According to the rule, central banks should increase short-term interest rates when one or both of the following occurs: the expected inflation rate exceeds the target inflation rate, or the anticipated GDP rate of growth exceeds its long-term rate of growth. Conversely, when inflation rates and GDP growth rates are below what was expected, interest rates are expected to decrease.

Formula for the Taylor Rule

Below is a simple formula used to calculate appropriate interest rates according to the Taylor rule:

Target Rate = Neutral rate + 0.5 (GDPe - GDPt) + 0.5 * (Ie - It).

Let's break down the formula and explore what each one of the terms means:

• Target rate: the interest rate that the central bank should target in the short term
• Neutral rate: the current short-term interest rate when the differences found among actual and expected inflation and GDP growth rates are equal to zero
• GDPe: expected GDP growth rate
• GDPt: long-term GDP growth rate
• Ie: expected inflation rate
• It: target inflation rate

How Does the Formula Work?

While you can find some Taylor rule calculators online that will do the work for you, let's explore an example to see if you can perform the calculations yourself.

We'll use the following variables:

• Long-term GDP growth rate of 2.5%
• An annual GDP growth rate of 3% during the first two months
• An expected rate of inflation of 4%

Now, let's plug those variables into the target rate formula:

Target short-term interest rate = 4% + 0.5 * (3% - 2.5%) + 0.5 * (4% - 2%) = 5.25%.

When compared to the targeted rates, the increased rate of inflation and the anticipated growth in GDP has made it necessary to increase interest rates to cool down the economy.

Benefits and Limitations of the Taylor Rule

There are three major benefits to using the Taylor rule:

To unlock this lesson you must be a Study.com Member.

Register to view this lesson

Are you a student or a teacher?

See for yourself why 30 million people use Study.com

Become a Study.com member and start learning now.
Back
What teachers are saying about Study.com

Earning College Credit

Did you know… We have over 200 college courses that prepare you to earn credit by exam that is accepted by over 1,500 colleges and universities. You can test out of the first two years of college and save thousands off your degree. Anyone can earn credit-by-exam regardless of age or education level.