What is Taylor Rule?

It was named Taylor’s rule after John. B.Taylor played with Dale W. Henderson and Warwick Mckibbin in 1993. It is a term or a tool that Central Banks use to appraise ideal short-term interest rates when the inflation rate does not match the expected inflation rate.

The Central Bank is a national bank that looks after a country’s commercial or governmental banking system, known as the Federal Reserve System.

Taylor Rule Formula

Target Rate = Neutral Rate + 0.5 (Difference in GDP Rate) + 0.5 (Difference in Inflation Rate)

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Explanation

A simple formula is used to calculate a simple interest rate as per Taylor’s rule is as follows: –

Target Interest Rate = Neutral Rate +0.5 (Difference in GDP Rate) +0.5 (Difference in Inflation Rate)

Now, let us understand the terms used in the above formula: –

Target Rate: The target rate is the interest rate, and the Central Bank’s target is short-term. It is often related to the risk-free rateRisk-free RateA risk-free rate is the minimum rate of return expected on investment with zero risks by the investor. It is the government bonds of well-developed countries, either US treasury bonds or German government bonds. Although, it does not exist because every investment has a certain amount of risk.read more in the economy. It is also known as the federal funds rate or overnight rate/interbank lending rate between banks for a short period.

Neutral Rate: The current short-term interest rate is where the difference between the actual inflation rate, target inflation rate, expected GDP rate, and long-term GDP growth rate is zero.

The difference in GDP rates is (GDPe-GDPt)

where;

  • GDPe- The expected growth rate of GDPGDPt- The target growth rate of GDP

The difference in Inflation rate is (Ie-It)

  • Ie – Expected inflation rateIt- Target inflation rate

Before the difference in GDP and inflation gap, the multiplier can be any number, but Taylor suggested it be 0.5.

Here, the important question arises relating to dynamic change in macroeconomic Macroeconomic Macroeconomics aims at studying aspects and phenomena important to the national economy and world economy at large like GDP, inflation, fiscal policies, monetary policies, unemployment rates.read moredevelopment, which will change the “neutral” value of the rate. The rate should neither be contractionary nor expansionary. Therefore, it would not tend to push unemployment above the target, and its effect should drive inflation above the mark.

If macroeconomic development leads to an increase in aggregate demand, it will increase inflation and decrease unemploymentUnemploymentUnemployment refers to a situation where individuals capable of working seek active opportunities for work but cannot find any for various reasons.read more, eventually raising the neutral interest rate and vice versa.

Examples of Taylor Rule Formula (with Excel Template)

Below are examples of the Taylor rule equation to understand better.

Example #1

Here are some of the few examples which will help us understand better: –

Solution

a) If the household wants to save more due to increasing life expectancy, they tend to look for a longer period of retirement which eventually lowers aggregate demand at any given interest rate, and the neural rate falls.

b) Similarly, if the government’s fiscal policy Fiscal PolicyFiscal policy refers to government measures utilizing tax revenue and expenditure as a tool to attain economic objectives. read more becomes expansionary, as sudden long tax cuts, more infrastructural and technology-driven spending will raise aggregate demandAggregate DemandAggregate Demand is the overall demand for all the goods and the services in a country and is expressed as the total amount of money which is exchanged for such goods and services. It is a relationship between all the things which are bought within the country with their prices.read more, leading to a rising neutral rate.

Example #2

Some of the variables that we will use, and by putting the said variable in the above formula, we shall be able to calculate our target rate:

  • Target inflation rate=1%Long-term GDP growth rate= 3%An annual GDP growth rate in the first two months = 3.5%Expected rate of inflation=2%.

The calculation of the target interest rate is as follows: –

  • = 2%+ 0.5 (3.5%-3%) + 0.5 (2%-1%)

The target interest rate will be: –

  • Target Interest Rate = 2.75 %

Now, the economy can be regulated better when the target rate increases by .75 % due to the rise in inflation rate and anticipated GDP growth.

Example #3

Suppose Mr. Noah and Mr. Kite work in the finance department of a renowned fitness and gym organization as Financial Analysts. They were assigned to specialize in debtDebtDebt is the practice of borrowing a tangible item, primarily money by an individual, business, or government, from another person, financial institution, or state.read more securities research in one of its departments to invest a larger sum, e.g., the gym department. In a certain year, 20XX, the economy started to grow at its long-term growth rate, and the inflation rate was set at its target rate of 3%. Also, the Federal Reserve had set its short-term interest rate at 5 %. Now on 05.02.20XX, suppose a meeting of the Federal Open Market Committee (FOMC) will be held within the week to decide whether the interest rate will be increased or not? Mr. Noah is now looking for certain hints to anticipate the decision and likely effect of a decision taken by FOMC. So, he approached Mr. Kite with the requisite information here: –

The expected inflation rate is 4.00%, with a long-term GDP growth rate of 2.8%. The annual growth rate of GDP in the first two months will continue at 2.00%. Now you need to know about the outcome of the FOMC meeting: –

Use the below-given data for calculation of target short term rate: –

The calculation of the target short term rate is as follows: –

  • = 5%+ 0.5 (2%-2.8%) + 0.5(5%-3%)

Target Short Term Rate will be –

  • Target Short Term Rate =5.60%

Based on this new data, FOMC will revise the short-term interest rate by 1.25 % to the new target rate of 5.25 %. The expected growth rate of GDP and the expected rate of inflation corresponding to the target have made it necessary to increase the interest rate to achieve balance in an economy and slow down.

Example #4

We will understand another practical industry example concerning banks: –

Taylor’s rule is a tool for Central Banks to determine their interest rate. We can use it to anticipate the interest rate based on the following inputs: –

  1. Potential output v/s. Real output

  2. Target inflation v/s. Actual inflation

It simply means that banks should raise short-term interest rates when inflation is above target, or

The GDPGDPGDP or Gross Domestic Product refers to the monetary measurement of the overall market value of the final output produced within a country over a period.read more growth rate is high, and lower its interest rate when inflation is below target or low. It can be a basic tool to stabilize the economy in the short runShort RunA Short Run in economics refers to a manufacturing planning period in which a business tries to meet the market demand by keeping one or more production inputs fixed while changing others.read more and stabilize inflation in the long run. In a nutshell, the Taylor rule, directly and indirectly, affects Community Banks.

Relevance and Use

Taylor’s rule emphasizes that real rates play a crucial role while formulating monetary policy Monetary PolicyMonetary policy refers to the steps taken by a country’s central bank to control the money supply for economic stability. For example, policymakers manipulate money circulation for increasing employment, GDP, price stability by using tools such as interest rates, reserves, bonds, etc.read more. Therefore, the real interest rate will cross equilibrium when inflation is set above the target rate, and output is above potential. One can use it in government, banks, etc.

This rule proves to be a benchmark for policymakers. It helps policy set in an economy through a systematic approach over time, which eventually helps produce good outcomes on average.

This rule also helps participants in the financial marketThe Financial MarketThe term “financial market” refers to the marketplace where activities such as the creation and trading of various financial assets such as bonds, stocks, commodities, currencies, and derivatives take place. It provides a platform for sellers and buyers to interact and trade at a price determined by market forces.read more forms a baseline for their expectations regarding the future course of monetary policy.

With the help of this rule, the Central Bank can easily communicate with the public, which is an important transmission mechanism of monetary policy.

The crux of Taylor’s rule is that the Federal Reserve should raise interest rates whenever inflation is high or employment is at its fullest level. On the contrary, interest rates should be decreased if employment levels and inflation rates are low.

This article is a guide to Taylor Rule Formula. We discussed calculating target short-term and interest rates using the Taylor rule formula with examples, and a downloadable Excel template.

  • Headline Inflation MeaningHeadline Inflation MeaningHeadline inflation is the comparison of a basket price of all the general commodities, such as groceries, food, beverages, gas, and accessories, in a given month of this year to the same basket price of all items in the same month last year.read moreDemand-Pull Inflation Demand-Pull InflationDemand-Pull Inflation is a type of inflation that occurs when the economy’s aggregate demand outweighs the economy’s aggregate supply, causing prices to rise.read moreInflationary Gap Inflationary GapThe inflationary gap is an output gap that represents the difference between the actual GDP and the anticipated GDP in any given economy under the assumption of full employment.read moreCost Push Inflation Cost-Push InflationCost-push inflation is the form of inflation caused by substantial increment in the cost of the factors of production like raw materials, labor, factory rent, etc. And the same cannot be altered as this has no appropriate alternative, which ultimately leads to a decrease in the supply of these inputs.read more