Taylor Rule

The Taylor Rule is a monetary policy rule in economics. The rule is called the Taylor Rule because it was proposed by John B. Taylor in 1993. It describes a central bank’s monetary policy when the bank determines its monetary policy based on price stability and economic output.

The Taylor rule is based on the observation that, in the United States at least, the central bank has a “dual mandate”. In particular, the Federal Reserve (FED) tries to maintain price stability and maximum employment. Such a mutual mandate can be summarized using the Taylor Rule for monetary policy. The rule states that the nominal interest rate (Rf) can be approximated as follows:

where the output gap is typically defined as the “percentage deviation of real GDP from its target”. The output gap measures whether output is above or below its ‘potential’.

The Taylor rule formula above clearly shows that nominal interest rate is determined both by inflation (price stability) and output gat (employment and growth). The Taylor rule formula therfore clearly reflects the dual mandate of the Fed.