What is the Taylor Rule and what does the theory suggest?

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What is the Taylor Rule and what does the theory suggest?

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According to basic economic theory, if the economy is “overheating” — as indicated by high inflation or abnormally high GDP — the central bank (e.g., the Federal Reserve) should act to increase interest rates to “cool down” the economy.

And conversely, when the economy is weak, interest rates should be lowered to encourage purchasing and “boost” production activity.

But there is a great debate among economists and politicians whether we should always follow this theory or not.

Increasing interest rates makes everything more expensive. The cost to service car loans, mortgages, credit card payments, all go up — and often hurt poor and elderly people the most. The public becomes unhappy and politicians feel the heat to keep interest rates low, especially in an election year.

As a result, many believe the central bank should use subjective ***discretion*** on when to adjust interest rates and by how much. They should take into account not only basic economic theory but also look at other factors such as the social impact of any adjustments.

Others disagree and believe that the central bank should follow a transparent ***rule*** to decide when interest rates should be adjusted (and by how much). They reason that yes, increasing interest rates when the inflation is already high might hurt many in the short run, but it is better for everyone in the long term. And the transparency by adopting such a rule gives clarity to the markets, businesses, homeowners, and the public in general.

John B. Taylor is an American economist who argues that the Federal Reserve should follow objective rules. He proposed an equation, [known as the Taylor Rule](https://en.wikipedia.org/wiki/Taylor_rule), to approximate what the Federal Reserve interest rate target should be.

The equation itself is not important. What’s important is the debate whether adjustments to economic policies (such as interest rates) should be made mostly **by discretion or by rule**. The Taylor Rule is one proposal on how interest rates should be targeted, but as noted others disagree.