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Chapter 26: Problem 3

What is the Taylor rule? What is its purpose?

Short Answer

Expert verified
The Taylor Rule is a prescriptive model that suggests how central banks should change nominal interest rates to counteract fluctuations in inflation, output, or employment. The purpose of the rule is to stabilize the economy by mitigating drastic economic changes, thus creating a more predictable economic landscape.

Step by step solution

01

Explanation of the Taylor Rule

The Taylor Rule, proposed by economist John Taylor in 1993, is a principle used for interest rate targeting. It is formulated to adjust and set suitable levels of interest rates in response to changes in economic conditions. By doing so, the rule intends to stabilize the economy by setting an ideal central bank policy rate.
02

Mathematical Representation

Mathematically, the Taylor rule is represented as follows:\(i = r^* + π + 0.5*(π - π^*) + 0.5*y\),where:- \(i\) is the nominal fed funds rate,- \(r^*\) is the assumed real equilibrium fed funds rate, usually set to 2%,- \(π\) is the rate of inflation,- \(π^*\) is the target inflation rate, usually 2%,- \(y\) is the output gap, the difference between actual and potential GDP in percentage.
03

Purpose of the Taylor Rule

The Taylor Rule serves a substantial role in policymaking by suggesting how central banks should change nominal interest rates to account for changes in inflation, output, or other economic conditions. This allows central banks to stabilize the economy by mitigating fluctuations, reaching maximum employment, and achieving stability in the prices of goods and services.

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Most popular questions from this chapter

(Related to the Chapter Opener on page 900) An investment blog said about Fed Chair Janet Yellen: "She is arguably the world's most powerful woman, and perhaps the most powerful person in the world. Can you name anybody with more might?" Do you agree with this assessment? Briefly explain.

The European Central Bank (ECB) issued the following statement after its June 2017 meeting on monetary policy: Regarding non-standard monetary policy measures, the Governing Council confirms that the net asset purchases, at the current monthly pace of \(€ 60\) billion, are intended to run until the end of December \(2017,\) or beyond, if necessary, and in any case until the Governing Council sees a sustained adjustment in the path of inflation consistent with its inflation aim. a. What is this nonstandard monetary policy of net asset purchases called? What other central banks have used it? b. Based on this statement, do you expect that the inflation rate is above or below the ECB's inflation target? Briefly explain.

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According to an article on cnbc.com, the Reserve Bank of India (RBI) was expected to lower its target interest rate at its early 2017 monetary policy meeting, but instead the RBI held its target constant. RBI Governor Urjit Patel "pointed to concerns that a 'fire sale' in perishable foods was distorting what could be a worrying outlook for inflation." a. What is a "fire sale” in perishable foods, and why would it distort the outlook for inflation? b. If the RBI ignored the fire sale in perishable foods, how might it be led to set the target interest rate at the wrong level?

A student says the following: "I understand why the Fed uses expansionary policy, but I don't understand why it would ever use contractionary policy. Why would the government ever want the economy to contract?" Briefly answer the student's question.
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