Taylor rule

Indian Economy glossary

Topic: Banking, Credit Creation and Monetary Policy · NCERT: Beyond NCERT

Meaning

The Taylor rule is a rule of thumb for setting the policy rate. It says the rate should rise when inflation is above target, or when output is above potential (the economy's normal full capacity). It should fall in the opposite cases. The formula is:

i = r* + π + 0.5(π − π*) + 0.5 × output gap

Here, i is the policy rate, r* is the neutral real rate, π is inflation, π* is the inflation target, and the output gap is actual output minus potential output. Central banks use it as a benchmark to check their decisions. It is not a law they must follow.

Example

Take r* = 1.5%, a target π* = 4%, actual inflation π = 5% and an output gap of zero. Then i = 1.5 + 5 + 0.5(5 − 4) + 0 = 7%. This means the rule would call for a policy rate of about 7%.

Don't confuse with

  • Inflation targeting: inflation targeting is the whole framework, such as India's 4% ± 2% target. The Taylor rule is only a formula for checking where the rate should be.

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