TAYLOR RULE:
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, the
Bank of England base rate in the UK),
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
).
[6] 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.
Entirely stolen from Wikipedia:
https://en.wikipedia.org/wiki/Taylor_rule
