Taylor rule

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Taylor rule

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From Wikipedia, the free encyclopedia

Not to be confused with Taylor Law, Taylor's law, or Taylor's theorem.

The Taylor rule is a monetary policy targeting rule. The rule was proposed in 1992 by American economist John B. Taylor[1] for central banks to use to stabilize economic activity by appropriately setting short-term interest rates.[2] The rule considers the federal funds rate, the price level and changes in real income.[3] The Taylor rule computes the optimal federal funds rate based on the gap between the desired (targeted) inflation rate and the actual inflation rate; and the output gap between the actual and natural output level. According to Taylor, monetary policy is stabilizing when the nominal interest rate is higher/lower than the increase/decrease in inflation.[4] Thus the Taylor rule prescribes a relatively high interest rate when actual inflation is higher than the inflation target.

In the United States, the Federal Open Market Committee controls monetary policy. The committee attempts to achieve an average inflation rate of 2% (with an equal likelihood of higher or lower inflation). The main advantage of a general targeting rule is that a central bank gains the discretion to apply multiple means to achieve the set target.[5]

The monetary policy of the Federal Reserve changed throughout the 20th century. The period between the 1960s and the 1970s is eval‎uated by Taylor and others as a period of poor monetary policy; the later years typically characterized as stagflation. The inflation rate was high and increasing, while interest rates were kept low.[6] Since the mid-1970s monetary targets have been used in many countries as a means to target inflation.[7] However, in the 2000s the actual interest rate in advanced economies, notably in the US, was kept below the value suggested by the Taylor rule.[8]

The Taylor rule is typically contrasted with discretionary monetary policy, which relies on the personal views of the monetary policy authorities. The Taylor rule often faces criticism due to the limited number of factors it considers.

Equation[edit]

According to Taylor's original version of the rule, the real policy interest rate should respond to divergences of actual inflation rates from target inflation rates and of actual Gross Domestic Product (GDP) from potential GDP:

��=��+��∗+��(��−��∗)+��(��−�¯�).

In this equation, ��

 is the target short-term nominal policy interest rate (e.g. the federal funds rate in the US, the Bank of England base rate in the UK), ��

 is the rate of inflation as measured by the GDP deflator, ��∗

 is the desired rate of inflation, ��∗

 is the assumed natural/equilibrium interest rate,[9] ��

 is the natural logarithm of actual GDP, and �¯�

 is the natural logarithm of potential output, as determined by a linear trend. ��−�¯�

 is the output gap. The ln⁡(1+�)=�

 approximation is used here.

Because of ��−��=real policy interest rate

,

Desired real policy interest rate=equilibrium real interest rate+��×difference from the inflation target+��×output gap

In this equation, both ��

 and ��

 should be positive (as a rough rule of thumb, Taylor's 1993 paper proposed setting ��=��=0.5

).[10] That is, the rule produces a relatively high real interest rate (a "tight" monetary policy) when inflation is above its target or when output is above its full-employment level, in order to reduce inflationary pressure. It recommends a relatively low real interest rate ("easy" monetary policy) in the opposite situation, to stimulate output. Sometimes monetary policy goals may conflict, as in the case of stagflation, when inflation is above its target with a substantial output gap. In such a situation, a Taylor rule specifies the relative weights given to reducing inflation versus increasing output.

Principle[edit]

By specifying ��>0

, the Taylor rule says that an increase in inflation by one percentage point should prompt the central bank to raise the nominal interest rate by more than one percentage point (specifically, by 1+��

, the sum of the two coefficients on ��

 in the equation). Since the real interest rate is (approximately) the nominal interest rate minus inflation, stipulating ��>0

 implies that when inflation rises, the real interest rate should be increased. The idea that the nominal interest rate should be raised "more than one-for-one" to cool the economy when inflation increases (that is increasing the real interest rate) has been called the Taylor principle. The Taylor principle presumes a unique bounded equilibrium for inflation. If the Taylor principle is violated, then the inflation path may be unstable.[11]

History[edit]

The concept of a policy rule emerged as part of the discussion on whether monetary policy should be based on intuition/discretion. The discourse began at the beginning of the 19th century. The first formal debate forum was launched in the 1920s by the US House Committee on Banking and Currency. In the hearing on the so-called Strong bill in 1923. the conflict in the views on the monetary policy clearly appeared. New York Fed Governor Benjamin Strong Jr., supported by Professors John R. Commons and Irving Fisher, was concerned about the Fed's practices that attempted to ensure price stability. In his opinion, Federal Reserve policy regarding the price level could not guarantee long-term stability. After the death of the congressman,[who?] a political debate on changing the Fed's policy was suspended. The Fed was dominated at that time by Strong and his New York Reserve Bank.

After the Great Depression hit the country, policies came under debate. Irving Fisher opined, "this depression was almost wholly preventable and that it would have been prevented if Governor Strong had lived, who was conducting open-market operations with a view of bringing about stability".[12] Later on, monetarists such as Milton Friedman and Anna Schwartz agreed that high inflation could be avoided if the Fed managed the quantity of money more consistently.[4]

The 1960s recession in the US was accompanied by relatively high interest rates. After the Bretton Woods agreement collapsed, policymakers focused on keeping interest rates low, which yielded the Great Inflation of 1970.

Since the mid-1970s money supply targets have been used in many countries to address inflation targets. Many advanced economies, such as the US and the UK, made their policy rates broadly consistent with the Taylor rule in the period of the Great Moderation between the mid-1980s and early 2000s. That period was characterized by limited inflation/stable prices. New Zealand went first, adopting an inflation target in 1990. The Reserve Bank of New Zealand was reformed to prioritize price stability, gaining more independence at the same time. The Bank of Canada (1991) and by 1994 the banks of Sweden, Finland, Australia, Spain, Israel and Chile were given the mandate to target inflation.[7]

Since the 2000s began the actual interest rate in advanced economies, especially in the US, was below that suggested by the Taylor rule. The deviation can be explained by the fact that central banks were supposed to mitigate the outcomes of financial busts, while intervening only given inflation expectations. Economic shocks were accompanied by lower rates.[8]

Alternative versions

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https://en.wikipedia.org/wiki/Taylor_rule