Editing New Keynesian economics (section)

====Taylor Rule====

In 1993,<ref>{{cite journal |last=Taylor |first=John B. |year=1993 |title=Discretion versus Policy Rules in Practice |journal=Carnegie-Rochester Conference Series on Public Policy |volume=39 |url=http://www.stanford.edu/~johntayl/Papers/Discretion.PDF |pages=195–214 |doi=10.1016/0167-2231(93)90009-L }} (The rule is introduced on page 202.)</ref> John B Taylor formulated the idea of a '''[[Taylor rule]]''', which is a reduced form approximation of the responsiveness of the [[nominal interest rate]], as set by the [[central bank]], to changes in inflation, [[Gross domestic product|output]], or other economic conditions. In particular, the rule describes how, for each one-percent increase in inflation, the central bank tends to raise the nominal interest rate by more than one percentage point. This aspect of the rule is often called the '''Taylor principle'''. Although such rules provide concise, descriptive proxies for central bank policy, they are not, in practice, explicitly proscriptively considered by central banks when setting nominal rates.

Taylor's original version of the rule describes how the nominal interest rate responds to divergences of actual inflation rates from ''target'' inflation rates and of actual gross domestic product (GDP) from ''potential'' GDP:

<math display="block">i_t = \pi_t + r_t^* + a_\pi  ( \pi_t - \pi_t^* )  + a_y ( y_t - y_t^* ).</math>

In this equation, <math>\,i_t\,</math> is the target short-term [[nominal interest rate]] (e.g. the [[federal funds rate]] in the US, the [[Official bank rate|Bank of England base rate]] in the UK), <math>\,\pi_t\,</math> is the rate of inflation as measured by the [[GDP deflator]], <math>\pi^*_t</math> is the desired rate of inflation, <math>r_t^*</math> is the assumed equilibrium real interest rate, <math>\,y_t\,</math> is the logarithm of real GDP, and <math>y_t^*</math> is the logarithm of [[potential output]], as determined by a linear trend.