John B. Taylor - Academic Contributions

Academic Contributions

Taylor’s research—including the staggered contract model, the Taylor rule, and the construction of a policy tradeoff (Taylor) curve employing empirical rational expectations models–has had a major impact on economic theory and policy. Federal Reserve Chairman Ben Bernanke has said that Taylor's “influence on monetary theory and policy has been profound,” and Federal Reserve Vice Chair Janet Yellen has noted that Taylor's work “has affected the way policymakers and economists analyze the economy and approach monetary policy."

Taylor contributed to the development of mathematical methods for solving macroeconomic models under the assumption of rational expectations, including in a 1975 Journal of Political Economy paper, in which he showed how gradual learning could be incorporated in models with rational expectations; a 1979 Econometrica paper in which he presented one of the first econometric models with overlapping price setting and rational expectations, which he later expanded into a large multicountry model in a 1993 book Macroeconomic Policy in a World Economy; and a 1982 Econometrica paper, in which he developed with Ray Fair the first algorithm to solve large-scale dynamic stochastic general equilibrium models which became part of popular solution programs such as Dynare and Eviews.

In 1977, Taylor and Edmund Phelps, simultaneously with Stanley Fischer, showed that monetary policy is useful for stabilizing the economy if prices or wages are sticky, even when all workers and firms have rational expectations. This demonstrated that some of the earlier insights of Keynesian economics remained true under rational expectations. This was important because Thomas Sargent and Neil Wallace had argued that rational expectations would make macroeconomic policy useless for stabilization; the results of Taylor, Phelps, and Fischer showed that Sargent and Wallace's crucial assumption was not rational expectations, but perfectly flexible prices.

Taylor then developed the staggered contract model of overlapping wage and price setting, which became one of the building blocks of the New Keynesian macroeconomics that rebuilt much of the traditional macromodel on rational expectations microfoundations.

Taylor’s research on monetary policy rules traces back to his undergraduate studies at Princeton. He went on in the 1970s and 1980s to explore what types of monetary policy rules would most effectively reduce the social costs of inflation and business cycle fluctuations: should central banks try to control the money supply, the price level, or the interest rate; and should these instruments react to changes in output, unemployment, asset prices, or inflation rates? He showed that there was a tradeoff—later called the Taylor curve—between the volatility of inflation and that of output. Taylor's 1993 paper in the Carnegie-Rochester Conference Series on Public Policy proposed that a simple and effective central bank policy would manipulate short-term interest rates, raising rates to cool the economy whenever inflation or output growth becomes excessive, and lowering rates when either one falls too low. Taylor's interest rate equation has come to be known as the Taylor rule, and it is now widely accepted as an effective formula for monetary decision making.

A key stipulation of the Taylor rule, sometimes called the Taylor principle, is that the nominal interest rate should increase by more than one percentage point for each one-percent rise in inflation. Some empirical estimates indicate that many central banks today act approximately as the Taylor rule prescribes, but violated the Taylor principle during the inflationary spiral of the 1970s.