Taylor’s Rule is an economic concept that suggests how central banks should set short-term interest rates based on balancing employment and inflation. The US Federal Reserve has generally adhered to the rule, which has helped keep inflation in check and maintain healthy levels of growth.
Taylor’s Rule is an economic concept that suggests how the US Federal Reserve or any central bank should set short-term interest rates. Proposed by a Stanford University economist, the rule is intended as a guideline for balancing complicated economic factors at the national level. Many experts suggest that the US Federal Reserve’s general adherence to the Taylor Rule has kept inflation in check throughout the United States.
The interest rate is a fee charged on borrowed money or assets. Lenders make most of their money through the interest charged on loans. In the United States, the Federal Reserve sets the interest rate at which banks can charge each other for interbank loans. Setting the reserve rate can stabilize the amount of money in the economy and help maintain inflation levels. Taylor’s rule is often followed as a rule of thumb for how the interest rate should be adjusted.
There are two concerns in setting interest rates: employment levels and inflation. Inflation is the devaluation of the purchasing power of money and can be caused by many problems in the economy. One of the most common reasons for inflation is that there is too much money in an economy, making every dollar worth less and driving up prices. Employment levels are seen as a measure of the health of the economy and can influence the purchasing power of consumers. High employment means better purchasing power, while lower employment means consumers have fewer free resources to borrow or invest.
There are three main factors that Taylor’s rule operates on. The first question is where the inflation rate compares to where the central bank wants it. If the inflation rate is higher than the target rate, interest rates should be raised to bring inflation down. This reduces the amount of money in the economy, meaning the purchase value of every dollar will increase.
The second principle of Taylor’s rule concerns the state of employment in the area concerned. If employment is at or above the maximum levels, the interest rate should be increased as employees are better able to afford loans. When employment is significantly below full levels, the rule suggests decreasing interest rates in order to lower prices to help people with lower-than-normal incomes.
The third factor is actually a combination of the first two principles. Under the rule, the correct short-term interest rate will be able to maintain an economy at full employment while remaining at targeted inflation rates. The third principle of Taylor’s rule seeks to balance conflict situations such as “stagflation,” when inflation is high despite high levels of employment. Ideally, the rule suggests, a healthy economy should be able to bring both employment and inflation into balance.
While the US Federal Reserve has not explicitly followed the guidelines, it has been widely accepted as a good way to set economic policy. Under Fed Chairman Alan Greenspan, US policy has generally followed the rules. Many believe that adhering to Taylor’s rules helped the US emerge from the huge inflation crisis of the 1970s and maintain mostly healthy levels of growth since the 1990s.
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