Taylor Rule - As An Equation

As An Equation

According to Taylor's original version of the rule, the nominal 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 interest rate (e.g. the federal funds rate in the US), is the rate of inflation as measured by the GDP deflator, is the desired rate of inflation, is the assumed equilibrium real interest rate, is the logarithm of real GDP, and is the logarithm of potential output, as determined by a linear trend.

In this equation, both and should be positive (as a rough rule of thumb, Taylor's 1993 paper proposed setting ). That is, the rule "recommends" a relatively high 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 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 while output is below full employment. In such a situation, a Taylor rule specifies the relative weights given to reducing inflation versus increasing output.