The Taylor Rule & Monetary Policy John Taylor, a Stanford University economist, developed a formula designed to provide

a central bank much like the Federal Reserve with recommendations as how to set short-term interest rates. Taylors rule accounts for the possibility of changing

economic conditions in order to achieve the short-term goal of stabilizing the economy as well as inflationary long-term goals. More specifically, Taylors rule is a monetary policy rule suggesting the central bank to change the nominal interest rate. Changes of the nominal interest rate are derived from deviations of actual GDP from the potential GDP or of actual inflation rates from that of the targeted rate of inflation. Taylors rule reads The equation aims to determine it,

which is the targeted short-term nominal interest rate or otherwise known in the United States as the federal funds rates. t is the rate of inflation measured by the GDP deflator, which is a measure of the level of prices of all new, domestically produced, final goods and services in an economy. Moreover, *t is the desired rate of inflation. Also in the equation is the assumed equilibrium real interest rate designated by r*t. Also , a

logarithm of potential output is subtracted from the measure of real GDP as represented by the logarithm yt. According to Taylors rule, the short-term interest rate should be determined by three independent factors. First, the short-term interest rate should be set in accordance to where actual inflation is relative to the targeted inflation level that the Fed is trying to attain. In combination with inflation levels, the short-term interest rate must take into account the level of full employment and its variance from current economic activity. Finally, Taylors rule depends on the factor of what the level of the short-term interest

rate should be in order to achieve full employment. Advantages of Taylors rule include avoiding the problem of time inconsistency as part of discretionary policy, in which monetary policy conducted on a day-to-day basis leads to inefficiencies or poor long-term outcomes. Taylors rule proposes to keep both a and ay as positive numbers to keep a high interest rate or a tight monetary policy when inflation rates exceed the targeted level or if the economy operates above the level of full employment. On the other hand, Taylors rule proposes a low interest rate, easy monetary policy, if inflation rates fall below the targeted level or if the economy is below the full employment level. The Fed does not explicitly follow Taylors rule. The rule has often been shown, however, to have accurately described the use of monetary policy utilized by the Fed since the creation of the rule. Similarly, the central banks of Canada and New Zealand also established similar observations as both developed countries focus of inflation targeting. The seemingly strong connection between the monetary policy used and the Taylor rule, although not openly used by the Fed, points to give reason to the controlled rate of inflation and relatively stable economy in the United States over the past decade. The Taylor rule also faces criticism. Although Taylors rule acts as a guide towards monetary policy, Athanasios Orphanides, in his work entitled The New Palgrave Dictionary of Economics, elaborates that the rule does not account for real-time data. Information limitations may, therefore, misguide policy makers who aim to maintain inflation targets. Nevertheless, the derivation of Taylors rule has thus far met the challenge of controlling the level of inflation and brought relative stability to the economy of the United States.

Bibliography Mishkin, Frederic S. Economics of Money, Banking and Financial Markets plus MyEconLab plus eBook 1-semester Student Access Kit, The (8th Edition) (MyEconLab Series). New York: Addison Wesley, 2006. Orphanides, Athanasios. "Taylor rules." The New Palgrave Dictionary of Economics. Second Edition. Palgrave Macmillan, 2008. The New Palgrave Dictionary of Economics Online. 31 March 2009 <http://www.dictionaryofeconomics.com/article?id=pde2008_T000215> The Taylor Rule: A Guidepost for Monetary Policy." Google. 31 Mar. 2009 <http://209.85.173.132/search?q=cache:Ckjdxk4Y_rsJ:www.clevelandfed.org/res earch/Commentary/2003/0703.pdf+taylor+rule+monetary+policy&cd=3&hl=en& ct=clnk&gl=us>. "What is Taylor's rule? (03/1998)." The Federal Reserve Bank of San Francisco: Economic Research, Educational Resources, Community Development, Consumer. 31 Mar. 2009 <http://www.frbsf.org/education/activities/drecon/9803.html>.