Taylor rule

Contents

Taylor rule is a prescriptive guideline for setting short-term interest rates that links a central bank's policy instrument to observable macroeconomic variables. It proposes how institutions such as the Federal Reserve System, European Central Bank, Bank of England, Bank of Japan, and Swiss National Bank might adjust the federal funds rate, European sovereign debt crisis responses, or policy rates in response to deviations of inflation and real GDP from targets. The rule has influenced debates among scholars at Stanford University, Harvard University, Princeton University, Massachusetts Institute of Technology, and policymakers including former chairs of the Federal Reserve Board.

Overview

The rule provides an operational link between an instrument (nominal short-term interest rate) and targets such as a price-stability mandate pursued by bodies like the Federal Reserve Board and the European Central Bank. It is often discussed alongside frameworks advocated by economists at National Bureau of Economic Research, International Monetary Fund, World Bank, Bank for International Settlements, and commentators from media outlets like the Wall Street Journal and Financial Times. Proponents cite clarity and systematic policy conduct as attributes valued in analyses by researchers affiliated with London School of Economics, University of Chicago, Yale University, Columbia University, and University of California, Berkeley.

The canonical specification expresses the policy rate as a function of the equilibrium real rate, the deviation of observed inflation from a target, and the output gap as estimated against potential output from models used at institutions such as the Congressional Budget Office and the Organisation for Economic Co-operation and Development. Variants incorporate elements proposed in literature from National Bureau of Economic Research, including interest-rate smoothing, real-time data revisions emphasized by scholars at Brookings Institution and Peterson Institute for International Economics, and versions that replace the output gap with measures of capacity utilization reported by Federal Reserve Bank of St. Louis and Eurostat. Extensions use forward-looking inflation expectations drawn from surveys by University of Michigan and market-based measures from Chicago Board Options Exchange indices.

The rule emerged in the early 1990s through academic work tied to authors at Stanford University and debate in venues such as American Economic Review and conferences convened by National Bureau of Economic Research and Federal Reserve Bank of Kansas City. Its promulgation influenced deliberations within central banks including the Federal Reserve Bank of New York, the Bank of England, and the European Central Bank. Contemporary discussions about rule-like behavior cite policy episodes such as the Volcker disinflation, the Great Moderation, the Global Financial Crisis of 2007–2008, and post-crisis responses coordinated at forums like the G20.

Advocates argue the rule promotes transparency and accountability for institutions like the Federal Reserve System and European Central Bank, aiding communication to legislators from bodies such as the United States Congress and the European Parliament. Critics, including authors associated with Austrian School commentators, heterodox scholars at New School for Social Research, and some central bank practitioners, point to problems when structural relationships change—illustrated by debates after episodes like the Global Financial Crisis of 2007–2008 and the European sovereign debt crisis. Practical objections raised in consensus venues such as the Bank for International Settlements and workshops at International Monetary Fund emphasize data revisions, measurement of potential output by the Congressional Budget Office, and the need for discretion in crises exemplified by responses coordinated through the G20.

Researchers and policymakers have proposed modifications that incorporate balance-sheet variables observed by the Federal Reserve Bank of New York, asset-price terms discussed in analyses of the S&L crisis, and financial-stability indicators monitored by the Financial Stability Board. Related prescriptions include versions influenced by Inflation targeting frameworks used by the Reserve Bank of New Zealand and the Bank of Canada, Taylor-type forward-looking rules discussed in papers from National Bureau of Economic Research, and augmented rules embedding exchange-rate considerations studied by scholars at International Monetary Fund and London School of Economics.

Category:Monetary policy