The Taylor Rule is a monetary policy guideline that suggests how central banks should adjust interest rates in response to changes in economic conditions. Formulated by economist John B. Taylor in 1993, it provides a systematic approach to setting interest rates based on two key factors: the deviation of actual inflation from the target inflation rate and the difference between actual output and potential output (often referred to as the output gap).
The rule can be expressed mathematically as follows:
where:
By following the Taylor Rule, central banks aim to stabilize the economy by adjusting interest rates to promote sustainable growth and maintain price stability, making it a crucial tool in modern monetary policy.
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