Wednesday, December 16, 2009

The Taylor Rule

Somebody asked FLG today about Bernanke as Person of the Year, and FLG brought up the Taylor Rule, which nobody had ever heard of.

Michael Woodford wrote a paper in 2001, entitled "The Taylor Rule and Optimal Monetary Policy," which unsurprisingly addresses the Taylor Rule and Optimal Monetary Policy. Here's the first couple sentences with some modifications because the characters don't copy well:

John Taylor (1993) has proposed that U.S. monetary policy in recent years can be described by an interest-rate feedback rule of the form

where it denotes the Fed's operating target for the federal funds rate, Pi t is the inflation rate (measured by the GDP deflator), yt is the log of real GDP, and y-bar t is the log of "potential output" (identi ed empirically with a linear trend). ). The rule has sincebeen subject to considerable attention, both as an account of actual policy in the U.S. and elsewhere, and as a prescription for desirable policy. Taylor argues for the rule's normative signi cance both on the basis of simulations and on the ground that it describes U.S. policy in a period in which monetary policy is widely judged to have been unusually successful (Taylor, 1999), suggesting that the rule is worth adopting as a principle of behavior.

What does this mean?  It's actually very simple.

 (the inflation rate + real interest rate) + (actual inflation - desired inflation) times some arbitrary number that economists came up with + (the log of GDP - the log of what economists think the pontential for GDP is) times some arbitrary number that economists came up with, and, voila, you have the optimal interest rate policy.

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