What is the Taylor rule?

• A. A fiscal policy rule that adjusts government spending and taxation in response to unemployment and GDP growth.
• B. A rule for maintaining a fixed exchange rate by adjusting the money supply to keep the domestic currency pegged to a foreign currency.
• C. A monetary guideline that sets the central bank's interest rate equal only to the current inflation rate, regardless of output conditions.
• D. A monetary policy rule that prescribes the central bank's nominal interest rate based on deviations of inflation from its target and the output gap (commonly expressed i = r* + π + 0.5(π − π*) + 0.5·output gap).

Answer: (D)

Verified step by step guidance

1. Understand that the Taylor rule is a monetary policy guideline used by central banks to set the nominal interest rate.
2. Recognize that the rule adjusts the interest rate based on two key economic indicators: the deviation of actual inflation from the target inflation rate, and the output gap (the difference between actual and potential output).
3. Express the Taylor rule mathematically as: \[i = r^{*} + \pi + 0.5(\pi - \pi^{*}) + 0.5 \times \text{output gap}\] where \(i\) is the nominal interest rate, \(r^{*}\) is the real equilibrium interest rate, \(\pi\) is the current inflation rate, \(\pi^{*}\) is the target inflation rate, and the output gap measures economic slack.
4. Interpret the components: the central bank raises the nominal interest rate when inflation is above target or when the economy is producing above its potential, and lowers it in the opposite cases.
5. Note that the Taylor rule helps central banks systematically respond to economic conditions to stabilize inflation and output, rather than setting interest rates arbitrarily.