### Taylor Rule and Interest Rates

The Taylor rule is a formula for setting interest rates depending on changes in the inflation rate and economic growth.

A simplified formula is: r = p + 0.5y + 0.5 (p - 2) + 2 (after Tobin, 1998)

Example of Taylor Rule:

The interesting thing is what the Taylor rule says about current interest rates. Since GDP in US has collapsed by - 4% (when growth trend is about 2%) it means that GDP is much lower than potential. Paul Krugman estimated that using the Taylor rule, the US should give a nominal interest rate of -7%. This indicates why the Federal Reserve are having to resort to quantitative easing. They can't cut interest rates below 0%, so they need to resort to unorthodox measures to boost the economy.

A simplified formula is: r = p + 0.5y + 0.5 (p - 2) + 2 (after Tobin, 1998)

- r = the short term interest rate in percentage terms per annum.
- p = the rate of inflation over the previous four quarters.
- y = the difference between real GDP from potential output.

- This assumes that target inflation is 2% and equilibrium real interest rate is 2%

Example of Taylor Rule:

- If inflation were to rise by 1%, the Taylor response would be to raise the interest rate by about 1.5%
- If GDP falls by 1% relative long run trend rate, then the Taylor response is to cut the interest rate by about 0.5%
- Basically, higher growth and inflationary pressures require higher interest rates to reduce economic activity. Lower growth and a fall in inflation require lower interest rates to boost spending.

### Interest Rates Too Low in US Using Taylor Rule

The interesting thing is what the Taylor rule says about current interest rates. Since GDP in US has collapsed by - 4% (when growth trend is about 2%) it means that GDP is much lower than potential. Paul Krugman estimated that using the Taylor rule, the US should give a nominal interest rate of -7%. This indicates why the Federal Reserve are having to resort to quantitative easing. They can't cut interest rates below 0%, so they need to resort to unorthodox measures to boost the economy.

### Taylor Rule and Suggested Interest Rate for US

- Interest rates explained
- source of graphs - Urbanomics Taylor Rule
- Taylor Rule - Bized

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*| By: T Pettinger |*Wednesday, May 13, 2009

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## 1 Comments:

I have always wondered why economic growth and inflation are seen together, one seems to be good, the other not... I understand it theoretically... But still the question stays in my mind...

I have never had the opportunity to ask this question from anyone, because I knew they would give me an answer that I already knew.

You know we are keen of economic growth... But then there comes inflation, I just don't get it. Which one is the cause of the other, and is there a certian inflation rate that helps the economy to grow, how can we calculate that desired inflation rate?

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