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Handout 4c - Handout 4c Taylor Rule The Taylor Rule in...

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Handout 4c – Taylor Rule Spring 2007 Page 1 of 2 The Taylor Rule in Words The Taylor rule is a formula developed by Stanford economist John Taylor. It was designed to provide “recommendations” or guidance for how a central bank like the Federal Reserve should set its short-term interest rate to meet its twin goals of full-employment and low inflation. John Taylor argued that a central bank responds to deviations from each of its goals by either raising or lowering its short-term interest rate. For instance, if the actual inflation rate rose above its desired rate, then a central bank should increase the interest rate to reduce the supply of money. Likewise, if current real GDP rose above potential GDP, then a central bank should increase the interest rate to reduce the supply of money. More importantly, Taylor argued that the central bank should respond equally to deviations from each of its goals.
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