In 1980, the U.S. inflation rate was 13.5 percent, and the unemployment rate reached 7.8 percent. Suppose that the target rate of inflation was 3 percent back then and the full employment rate of unemployment was 6 percent at that time. What value does the Taylor Rule predict for the Fed’s target interest rate? Would you be surprised to learn that the Fed’s targeted interest rate (the federal funds rate) reached 18.9 percent in December 1980?

The inflation gap for the current actual inflation rate of 13.5% and inflation target of 3% will be

Inflation gap = 13.5 – 3 = 10.3%

The unemployment gap for the current actual unemployment rate of 7.8% and unemployment rate target of 6% will be

Unemployment gap = 7.8 – 6 = 1.8%

To obtain the target interest rate, Taylor’s formula is

Target interest rate = 2 + current actual inflation rate + 0.5 (inflation gap) – unemployment gap.

Where 2 is the risk-free interest rate, based on historical data.

Then,

$$\begin{gathered} targetinterestrate=2+13.5+\left(0.5\times 10.5\right)-1.8 \\ =18.95 \end{gathered}$$

Thus, according to Taylor’s rule, Fed’s target interest rate is 18.95%.

The Taylor rule stipulates how the Fed should set its nominal interest rate target in response to

(a) divergences of the actual unemployment rate from the full-employment rate of unemployment and

(b) divergences of the real inflation rate from the Fed’s inflation target.

The coefficient on the inflation gap is 0.5 while the coefficient on the unemployment gap is 1.0; that is, the policymakers care twice as much about the unemployment gap because the unemployment gap’s coefficient of 1.0 is twice as significant as the inflation gap’s coefficient 0.5.

The target interest rate of 18.9% in 1980 is surprisingly high and shows how significant the deviations are from the center of the bullseyes.