Interactive modelAdvanced Macro & Growthintermediate

Taylor Rule

The interest-rate rule that describes (and prescribes) how central banks respond to inflation and gaps.

Equilibrium: π* = 3.0, i* = 5.5

Current equations

Taylor rule: i = 1 + 1.5·ππ now: π = 3

A one-line description of what central banks do: start from the neutral rate, add inflation, and push harder when inflation strays from target. The line's steepness. 1.5, not 1, is the whole secret.

Source: Taylor (1993); Blanchard ch. 23

Shift the curves

Current inflation (π)0

The rule responds MORE than one-for-one (slope 1.5): real rates rise when inflation rises, the Taylor principle.

The Taylor Rule model, in writing

Definition

A simple formula describing how central banks set interest rates: respond to inflation above target and output above potential, and move the nominal rate MORE than one-for-one with inflation.

i = r* + π + 0.5(π − π*) + 0.5(y − y*)

The intuition

The more-than-one-for-one response (the Taylor principle) is the crucial part: if inflation rises 1% and the nominal rate rises only 0.5%, the REAL rate falls and policy accidentally stimulates an overheating economy. Central banks that violated the principle (the 1970s Fed) got spiralling inflation; those that follow it anchor expectations.

Exam tip

Check the coefficient on inflation: stability requires it to exceed 1 in nominal terms. Plugging numbers into the rule and comparing with the actual cash rate is a common data question.

Related models in Advanced Macro & Growth

IS-LM →Mundell-Fleming (Open-Economy IS-LM) →Fisher Equation →Government Budget Constraint & Seigniorage →