The Taylor Rule is an economic concept that suggests how central banks should set short-term interest rates to balance inflation and employment levels. The US Federal Reserve has generally adhered to the rule, which is believed to have helped maintain healthy growth levels since the 1990s.
The Taylor Rule is an economic concept that suggests how the US Federal Reserve or any central bank should set short-term interest rates. Proposed by an economist at Stanford University, the rule is intended as a guide for balancing difficult 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 across the United States.
Interest rate is a fee charged for borrowed money or assets. Lenders make most of their money through the interest charged on the 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 general rule of thumb for how the interest rate should be adjusted.
Two concerns influence the setting of 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 each dollar worth less and causing prices to rise. Employment levels are considered a measure of the health of the economy and can affect 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 on which Taylor’s rule operates. The first question is where does the inflation rate compare to where the central bank wants it. If the inflation rate is higher than the target rate, interest rates should be increased to reduce inflation. This reduces the amount of money in the economy, which means that the purchase value of each dollar will increase.
The second principle of Taylor’s rule concerns the status of employment in the affected area. If employment is equal to or higher than full levels, the interest rate should be increased as employed people can repay loans better. When employment is significantly lower than full levels, the rule suggests lowering interest rates to lower prices and help people with lower incomes than usual.
The third factor is actually a combination of the first two principles. According to the rule, the correct short-term interest rate will be able to maintain an economy at full employment as long as it stays at specified inflation rates. The third principle of Taylor’s rule tries to ensure a balance between conflicting situations such as ‘stagflation’, when inflation is high despite high levels of employment. Ideally, the rule suggests, a healthy economy should be able to balance both employment and inflation.
While the US Federal Reserve has not explicitly followed the guidelines, they have been widely accepted as a good way to determine economic policy. Under Fed Chairman Alan Greenspan, US policy generally followed the rules. Adherence to the Taylor rules is believed by many to have helped the United States emerge from the huge inflation crisis of the 1970s and maintain mostly healthy growth levels since the 1990s.
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