Taylor Rule

BIBLIOGRAPHY

In the late 1950s the Phillips curve became the dominant policy model, prescribing a trade-off between the wage and inflation rate against the unemployment rate. In the 1960s the parameters of the Phillips curve began to drift. Adaptive expectation with and without the natural rate and NAIRU (nonaccelerating inflation rate of unemployment) hypotheses was added to the curve. Later, the rational expectations hypothesis, which brought into question the assumptions of full information and variation between the actual and theoretical parameters of models, became popular. In 1979 and 1993, to improve predictions in line with the Phillips curve, the American economist John B. Taylor (b. 1946) introduced the Taylor curve, which specifies variance, rather than rate, in output and inflation to explain the great moderation in macro-economic data since the 1970s.

Taylor advanced policy arguments—including that the variance of inflation and real gross domestic product (GDP) could be reduced to minimum levels—and empirical justifications for the Taylor rule. The rule is, where r is the federal fund rate, p is the inflation rate, and y is the percentage deviation of real GDP from a potential level. The Federal Open Market Committee (FOMC), the committee within the Federal Reserve that sets the target federal fund rate, can use this rule as a guide. The evidence shows a high correlation between the actual federal fund rate and estimates from the rule for the period from 1987 to 2005, with peaks and troughs matching up closely in most years.

The Taylor rule has many novel features. It transcends the “either/or” nature of the rules versus discretion debate by making room for discretionary policies as well. It is neither a fixed rule nor one that expands the money supply to approximately the growth rate of output as Milton Friedman (1983) proposed. A fixed policy rule would not be useful to the FOMC because, besides lacking a feedback mechanism, it would shun the Fed’s responsibility to stabilize cyclical swings, rendering the Fed passive. Even when the public acts with rational expectations and policymakers have full information, the Fed may want to choose a time-inconsistent or suboptimal policy such as when a change in administration occurs. A new administration may want changes, encouraging the FOMC to choose sequentially, such as setting interest rate targets meeting-by-meeting.

Another novelty is that the Taylor rule is not necessarily optimal in the sense of a single point on the tradeoff in the production-possibility-like frontier. While Robert M. Solow argued for precise estimates, Taylor inferred robust estimates for a broader group of models. Generally, rules are considered prescriptive or normative in nature, as Taylor originally intended them to be, but the Taylor rule turned out to be very descriptive as well.

One area for further research is to find the reliable equilibrium federal fund rate and potential GDP estimates in a more forward-looking environment. This may mean that changes in the money supply advocated by other rules should be considered. Just as patents require laws to encourage inventiveness, the Taylor rule requires commitment to make it credible. In the early twenty-first century, the Taylor rule is an active research program that is attracting much attention in the literature

SEE ALSO Economics, New Classical; Economics, New Keynesian; Expectations, Rational; Federal Reserve System, U.S.; Macroeconomics; Monetarism; Monetary Theory; Phillips Curve; Policy, Monetary; Rules Versus Discretion; Variance

BIBLIOGRAPHY

Blanchard, Olivier. 2006. Macroeconomics. 4th ed. Upper Saddle River, NJ: Pearson Prentice Hall.

Friedman, Milton. 1983. The Case for a Monetary Rule. In Bright Promises, Dismal Performance: An Economist’s Protest, ed. William R. Allen, 225–227. San Diego: Harcourt Brace Jovanovich.

Kydland, Finn E., and Edward C. Prescott. 1977. Rules Rather than Discretion: The Inconsistency of Optimal Plans. Journal of Political Economy 85 (3): 473–492.

Poole, William. 1998. Comments. In Inflation, Unemployment, and Monetary Policy, by Robert M. Solow and John B. Taylor, 78–88. Cambridge, MA: MIT Press.

Solow, Robert M., and John B. Taylor. 1998. Inflation, Unemployment, and Monetary Policy, ed. Benjamin M. Friedman. Cambridge, MA: MIT Press.

Taylor, John B. 1979. Estimation and Control of a Macroeconomic Model with Rational Expectations. Econometrica 47 (5): 1267–1286.

Taylor, John B. 1993. Discretion versus Policy Rules in Practice. Carnegie-Rochester Conference Series on Public Policy 39: 195–214.

Taylor, John B. 1999. A Historical Analysis of Monetary Policy Rules. In Monetary Policy Rules, ed. John B. Taylor, 319–341. Chicago: University of Chicago Press.

Lall Ramrattan

Michael Szenberg