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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:
The targeted rate of inflation in relation to the actual inflation rates
The real levels of employment, as opposed to full employment
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:
It can provide a useful benchmark to legislators and policy makers in relation to the economy.
In the financial markets, the rule helps participants form a baseline for calculating prospects about future economic policy.
Simple rules, such as the Taylor rule, make it easy for the Federal Reserve and other organizations to communicate with the public.
The Taylor rule also has three major limitations:
Different groups or agencies may come up with different inflation rates based on their perspective, making results inconsistent.
Because real interest rates and potential output are not observable, they can be subjective.
Because of the complexity of the United States and other countries' economies, rules with a small number of variables are unable to capture all of the important factors.
The Taylor rule, named after John Taylor, the Stanford University economist who developed it, is a monetary principle that helps central banks manage interest rates. It is based upon three factors: inflation rates, interest rates, and levels of employment. Central banks, or national banks, use the Taylor rule to make estimates of ideal short-term interest rates when the existing inflation rate does not match the expected inflation rate. The main aim of the Taylor rule is to bring stability to the economy for the near term, while still sustaining long-term expansion. Although it has several benefits, its limitations include the subjectivity of real interest rates and potential output.
For a quick recap, here's the formula for the Taylor rule and its variables explained:
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