Taylor's Rule

**Taylor's Rule** is a monetary policy rule that is used to set the target federal funds rate. The rule is named after John Taylor, a Stanford University economist who first proposed it in 1993.

Taylor's Rule is based on the idea that the federal funds rate should be set at a level that is consistent with the central bank's inflation target and output goals. The rule takes into account three factors:

* The current inflation rate
* The target inflation rate
* The output gap (the difference between actual output and potential output)

The rule is expressed as follows:

```
Federal funds rate = r* + p* + 0.5(p - p*) + 0.5(Y - Y*)
```

where:

* r* is the real interest rate (the nominal interest rate minus inflation)
* p* is the target inflation rate
* p is the current inflation rate
* Y is actual output
* Y* is potential output

The first term in the equation, r*, is the real interest rate. This is the interest rate that would be set in the absence of inflation. The second term, p*, is the target inflation rate. This is the inflation rate that the central bank is trying to achieve. The third term, 0.5(p - p*), is the response of the federal funds rate to changes in inflation. This term is positive, which means that the federal funds rate will be increased if inflation rises above the target rate. The fourth term, 0.5(Y - Y*), is the response of the federal funds rate to changes in the output gap. This term is also positive, which means that the federal funds rate will be increased if the output gap is negative (i.e., if actual output is below potential output).

Taylor's Rule is a simple and effective way to set the federal funds rate. It takes into account the three key factors that affect the economy: inflation, output, and interest rates. The rule has been used by the Federal Reserve since 1995, and it has helped to keep inflation low and stable.

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Taylor's Rule has been praised for its simplicity and its ability to keep inflation low and stable. However, the rule has also been criticized for being too rigid. Some economists argue that the rule should be more flexible, and that it should take into account other factors, such as the financial cycle and the housing market.

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Despite these criticisms, Taylor's Rule remains a popular monetary policy rule. It is simple to understand, and it has been shown to be effective in keeping inflation low and stable. However, the rule may need to be modified in the future to take into account other factors, such as the financial cycle and the housing market.