Taylor Rule

The Taylor rule is a simple monetary policy formula proposed by economist John Taylor in 1993, prescribing how central banks should set short-term interest rates in response to deviations of inflation from target and of GDP from potential output. The original formulation states that the federal funds rate should equal the sum of the inflation rate, the equilibrium real interest rate, plus half the inflation gap and half the output gap. The rule gained prominence because it appeared to track actual Federal Reserve behavior with surprising accuracy during the Great Moderation.

The Taylor rule's elegance is also its limitation. It assumes a stable relationship between interest rates and macroeconomic outcomes, ignores financial stability concerns, and cannot accommodate the zero lower bound that constrained policy after 2008. Its apparent success in the 1990s and early 2000s may reflect not its universal validity but its fitness for a specific regime — one in which financial instability was suppressed rather than eliminated. As a prescriptive framework, it remains influential; as a descriptive model, it is increasingly treated as a benchmark rather than a law.