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The Taylor Rule formula was first presented by Taylor, who noted that it accurately reflected Federal Reserve policy for several years prior to 1993 but also referred to it as a “concept” in a setting where it is practically impossible to follow any specific algebraic formula that describes the policy rule mechanically.
In accordance with the rule, the federal funds rate should be higher when inflation is greater than the Fed’s inflation objective and lower when inflation is lower. Like this, real GDP growth that exceeds a target—typically determined by the economy’s full potential—would require a higher interest rate, while growth that falls short of the objective would lead to a reduction.
Taylor’s equation appears as follows in its most basic form:
r = p + 0.5y + 0.5(p – 2) + 2
Where:
Nominal Fed Funds Rate = r
p equals the inflation rate
y is the percentage difference between the long-term linear trend in GDP and the current real GDP.
During generally stable times characterized by steady growth and moderate inflation, the Taylor Rule has tended to be a reliable guide for monetary policy, but considerably less so during economic crises. Since monetary policy loses its effectiveness at negative interest rates, central banks have used alternative instruments to combat severe economic crises, such as massive asset purchases, often known as quantitative easing. The fundamental Taylor Rule does not take these possibilities into account.
