*Jennifer Francis*Show bio

Jennifer has a Masters Degree in Business Administration and pursuing a Doctoral degree. She has 14 years of experience as a classroom teacher, and several years in both retail and manufacturing.

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Instructor:
*Jennifer Francis*
Show bio

Jennifer has a Masters Degree in Business Administration and pursuing a Doctoral degree. She has 14 years of experience as a classroom teacher, and several years in both retail and manufacturing.

In economics, the Taylor rule helps central banks determine how interest rates should be changed to promote economic growth. Explore the definition, formula, and examples for the Taylor Rule in economics, learn the formula for the rule, and recognize its benefits and limitations.
Updated: 10/15/2021

The **Taylor rule**, created by John Taylor, an economist at Stanford University, is a principle used in the management of interest rates. For example, central banks use the rule to make estimates of ideal short-term interest rates when there is an inflation rate that does not match the expected inflation rate. A **central bank** is a national bank that oversees a country's commercial or governmental banking system, such as the Federal Reserve System. It may also distribute currency or oversee monetary policies.

It is also useful when the expected **gross domestic product (GDP)** is different from the actual GDP growth in the long term. The GDP is the total cost of products and services delivered by an individual country in one year.

The main aim of the Taylor rule is to bring stability to the economy for the near term, while still sustaining long-term expansion. Let's take a look at some of its guiding principles.

The Taylor rule is based upon three factors:

- The targeted rate of inflation in relation to the actual inflation rates
- The real levels of employment, as opposed to full employment
- An interest rate consistent with full employment in the short term

According to the rule, central banks should increase short-term interest rates when one or both of the following occurs: the expected inflation rate exceeds the target inflation rate, or the anticipated GDP rate of growth exceeds its long-term rate of growth. Conversely, when inflation rates and GDP growth rates are below what was expected, interest rates are expected to decrease.

Below is a simple formula used to calculate appropriate interest rates according to the Taylor rule:

Target Rate = Neutral rate + 0.5 (GDPe - GDPt) + 0.5 * (Ie - It).

Let's break down the formula and explore what each one of the terms means:

**Target rate**: the interest rate that the central bank should target in the short term**Neutral rate**: the current short-term interest rate when the differences found among actual and expected inflation and GDP growth rates are equal to zero**GDPe**: expected GDP growth rate**GDPt**: long-term GDP growth rate**Ie**: expected inflation rate**It**: target inflation rate

While you can find some Taylor rule calculators online that will do the work for you, let's explore an example to see if you can perform the calculations yourself.

We'll use the following variables:

- Long-term GDP growth rate of 2.5%
- An annual GDP growth rate of 3% during the first two months
- An expected rate of inflation of 4%

Now, let's plug those variables into the target rate formula:

Target short-term interest rate = 4% + 0.5 * (3% - 2.5%) + 0.5 * (4% - 2%) = 5.25%.

When compared to the targeted rates, the increased rate of inflation and the anticipated growth in GDP has made it necessary to increase interest rates to cool down the economy.

There are three major benefits to using the Taylor rule:

- It can provide a useful benchmark to legislators and policy makers in relation to the economy.
- In the financial markets, the rule helps participants form a baseline for calculating prospects about future economic policy.
- Simple rules, such as the Taylor rule, make it easy for the Federal Reserve and other organizations to communicate with the public.

The Taylor rule also has three major limitations:

- Different groups or agencies may come up with different inflation rates based on their perspective, making results inconsistent.
- Because real interest rates and potential output are not observable, they can be subjective.
- Because of the complexity of the United States and other countries' economies, rules with a small number of variables are unable to capture all of the important factors.

The **Taylor rule**, named after John Taylor, the Stanford University economist who developed it, is a monetary principle that helps central banks manage interest rates. It is based upon three factors: inflation rates, interest rates, and levels of employment. Central banks, or national banks, use the Taylor rule to make estimates of ideal short-term interest rates when the existing inflation rate does not match the expected inflation rate. The main aim of the Taylor rule is to bring stability to the economy for the near term, while still sustaining long-term expansion. Although it has several benefits, its limitations include the subjectivity of real interest rates and potential output.

For a quick recap, here's the formula for the Taylor rule and its variables explained:

Target Rate = Neutral rate + 0.5 (GDPe - GDPt) + 0.5 * (Ie - It)

**Target rate**: the interest rate that the central bank should target in the short term**Neutral rate**: the current short-term interest rate when the differences found among actual and expected inflation and GDP growth rates are equal to zero**GDPe**: expected GDP growth rate; remember that GDP is**gross domestic product**, or the total cost of products and services delivered by an individual country in one year**GDPt**: long-term GDP growth rate**Ie**: expected inflation rate**It**: target inflation rate

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