The Taylor rule determines the target interest rate using the neutral rate, expected GDP relative to its long-term trend, and expected inflation relative to its targeted amount. In essence, the Taylor rule links a central bank’s target short-term nominal interest rate to the expected growth rate of the economy and inflation, relative to trend growth and the central bank’s inflation target.
It is used as a prescriptive tool (i.e., it states what the central bank should do). It also is fairly accurate at predicting central bank action.
However, even if a central bank were to set its policy rate according to the Taylor rule, there could still be substantial judgment left in the process. None of the inputs to the rule are objectively observable. To make the rule operational, policymakers and their staffs have to specify how the requisite expectations will be generated, and by whom.
It can be formalized as follows:
ntarget = rneutral + iexpected + [0.5(GDPexpected − GDPtrend) + 0.5(iexpected − itarget)]
ntarget = target nominal short-term interest rate
rneutral = neutral real short-term interest rate
GDPexpected = expected GDP growth rate
GDPtrend = long-term trend in the GDP growth rate
iexpected = expected inflation rate
itarget = target inflation rate
The Taylor Rule can also be expressed in terms of the real inflation-adjusted target rate by moving expected inflation to the left-hand side of the equation.
ntarget − iexpected = rneutral + [0.5(GDPexpected − GDPtrend) + 0.5(iexpected − itarget)]