What Is the Taylor Rule?

The Taylor rule (John Taylor, 1993) is a simple formula describing how a central bank should set its policy interest rate:

rate = r* + inflation + 0.5·(inflation − target) + 0.5·(output gap)

The Taylor Principle

The key feature is that the response to inflation is greater than one-for-one (a coefficient of 1.5 on inflation). That matters because what cools the economy is the real (inflation-adjusted) rate. If inflation rises 1 point and the central bank raises the nominal rate by only 1 point, the real rate is unchanged and nothing happens. Raising it by more than 1 point lifts the real rate and actually restrains demand. Follow this principle and inflation is stable; violate it and inflation can spiral.

Why it is the benchmark

The rule closely tracks what major central banks actually did during the stable decades, so it became the reference point economists use to judge whether policy is too loose or too tight. It is one of the three equations in the standard teaching model of monetary policy.

In the simulator you can switch the central bank to manual control and try to beat inflation yourself, which quickly teaches why rates have to get above the inflation rate to bite. Source: Taylor (1993); see the methodology.