Political Economy Keynesian Economics Questions Medium
The Taylor rule is a concept in Keynesian Economics that provides a guideline for central banks to set their target interest rates based on the prevailing economic conditions. It was developed by economist John Taylor in the 1990s as a way to determine the appropriate level of interest rates to achieve macroeconomic stability.
According to the Taylor rule, the central bank should adjust its target interest rate in response to changes in inflation and the output gap. The rule suggests that the target interest rate should be set as a function of the inflation rate and the difference between actual and potential output.
In its simplest form, the Taylor rule can be expressed as follows:
Target interest rate = Neutral interest rate + (1.5 x Inflation rate) + (0.5 x Output gap)
The neutral interest rate represents the level of interest rates that would be appropriate in an economy with stable inflation and full employment. The inflation rate is the percentage change in the general price level, while the output gap measures the difference between actual and potential output.
The Taylor rule implies that when inflation is above the target level or the output gap is positive (indicating an overheating economy), the central bank should raise interest rates to cool down the economy and reduce inflationary pressures. Conversely, when inflation is below the target level or the output gap is negative (indicating a sluggish economy), the central bank should lower interest rates to stimulate economic activity and boost inflation.
By following the Taylor rule, central banks aim to achieve price stability and promote sustainable economic growth. However, it is important to note that the Taylor rule is a simplified model and may not capture all the complexities of the real economy. Central banks often take into account other factors and use their discretion in setting interest rates.