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Finance Calc Kit
Inflation

Taylor Rule

Calculate the target federal funds rate using the Taylor Rule formula.

Taylor Rule inputs

%
%
%
%

Target federal funds rate

6.00%

Nominal policy rate implied by the Taylor Rule

Formula breakdown

Equilibrium real rate
2.00%
Current inflation
+3.00%
Inflation gap adjustment
+0.50%
Output gap adjustment
+0.50%
A high target rate suggests restrictive monetary policy may be needed to control inflation or cool an overheating economy.

Taylor Rule calculation

Open to see each step from your inputs to the result.

  1. Start with the equilibrium real rate and current inflation

    r∗+π=2.00%+3.00%r^* + \pi = 2.00\% + 3.00\%

    The base nominal rate before gap adjustments equals 5.00%.

  2. Apply the inflation gap adjustment

    aπ(π−π∗)=0.50×(+1.00)a_\pi(\pi - \pi^*) = 0.50 \times (+1.00)

    The inflation gap term equals +0.50%.

  3. Apply the output gap adjustment

    ay(y−y∗)=0.50×(+1.00)a_y(y - y^*) = 0.50 \times (+1.00)

    The output gap term equals +0.50%.

  4. Sum all components for the target policy rate

    i∗=r∗+π+aπ(π−π∗)+ay(y−y∗)i^* = r^* + \pi + a_\pi(\pi - \pi^*) + a_y(y - y^*)

    2.00 + 3.00 + (0.50) + (0.50) = 6.00%

Report tool

What is the Taylor Rule?

The Taylor Rule is a monetary policy guideline proposed by economist John Taylor in 1993. It suggests how a central bank should set its short-term nominal interest rate in response to inflation and real economic activity. The rule provides a transparent benchmark for whether current policy is accommodative, neutral, or restrictive relative to macroeconomic conditions.

Policymakers and analysts use the Taylor Rule alongside models like the Phillips curve calculator and the GDP gap calculator to connect inflation, unemployment, and output slack. To separate nominal rates from inflation, see the Fisher effect calculator and real interest rate calculator.

Taylor Rule formula

i∗=r∗+π+aπ(π−π∗)+ay(y−y∗)i^* = r^* + \pi + a_\pi(\pi - \pi^*) + a_y(y - y^*)

Where i∗i^* is the target nominal policy rate (such as the federal funds rate), r∗r^* is the equilibrium real interest rate, π\pi is current inflation, π∗\pi^* is the inflation target, y−y∗y - y^* is the output gap, aπa_\pi is the inflation gap weight, and aya_y is the output gap weight.

Worked example: standard 1993 rule

Suppose the equilibrium real rate is 2%, current inflation is 3%, the inflation target is 2%, and the output gap is +1% (the economy is running above potential). Using the standard coefficients aπ=0.5a_\pi = 0.5 and ay=0.5a_y = 0.5:

  1. Base rate: r∗+π=2%+3%=5%r^* + \pi = 2\% + 3\% = 5\%
  2. Inflation gap term: 0.5×(3%−2%)=+0.5%0.5 \times (3\% - 2\%) = +0.5\%
  3. Output gap term: 0.5×1%=+0.5%0.5 \times 1\% = +0.5\%
  4. Target rate: i∗=5%+0.5%+0.5%=6%i^* = 5\% + 0.5\% + 0.5\% = 6\%

A 6% target suggests policy should be tighter than the base 5% nominal rate because inflation is above target and output is running hot.

Rule variants: 1993 vs 1999

  • Standard Taylor Rule (1993): Uses aπ=0.5a_\pi = 0.5 and ay=0.5a_y = 0.5. This original formulation closely tracked U.S. policy in the late 1980s and early 1990s.
  • Balanced Taylor Rule (1999): Keeps aπ=0.5a_\pi = 0.5 but raises aya_y to 1.0, implying a stronger response to output gaps while maintaining the same inflation sensitivity.

Understanding the output gap

Output Gap=Real GDP−Potential GDPPotential GDP×100\text{Output Gap} = \frac{\text{Real GDP} - \text{Potential GDP}}{\text{Potential GDP}} \times 100

A positive output gap means actual GDP exceeds potential GDP, signaling inflationary pressure from an overheating economy. A negative gap means slack, with idle capacity and elevated cyclical unemployment. The Taylor Rule raises the target rate when the gap is positive and lowers it when the gap is negative.

The Taylor Principle and inflation fighting

When aπ>1a_\pi > 1, the Taylor Principle holds: a 1 percentage point rise in inflation triggers a more than 1 percentage point increase in the nominal rate, so the real interest rate rises and helps cool demand. With the standard coefficient of 0.5, the rule still raises rates when inflation exceeds target, but the real rate may not rise as sharply. Central banks often debate whether coefficients should exceed 1.0 during high-inflation episodes.

Frequently asked questions

What happens when the output gap is positive?
A positive output gap means actual GDP is above potential GDP. The economy is operating above sustainable capacity, which can push wages and prices higher. The Taylor Rule responds by raising the target interest rate to slow demand and reduce inflationary pressure.
Why is the inflation target usually set to 2%?
A 2% inflation target is widely used by central banks including the Federal Reserve. It is high enough to avoid deflation risk (falling prices that can stall spending) while low enough to preserve purchasing power stability over time.
How does the Taylor Rule respond to inflation above target?
When current inflation exceeds the target, the term (pi - pi*) is positive and adds to the recommended policy rate. The larger the inflation gap and the higher the inflation weight coefficient, the more the rule calls for rate hikes.
Does the Federal Reserve follow the Taylor Rule exactly?
No. The Federal Reserve considers the Taylor Rule as one benchmark among many. Actual policy also reflects financial stability risks, global conditions, forward guidance, and judgment that simple rules cannot capture.
What is r* (the equilibrium real interest rate)?
r* is the real short-term interest rate consistent with the economy operating at full employment and stable inflation. It is not directly observable and is estimated from trend growth, demographics, and productivity. A common starting assumption is 2%, but estimates vary over time.

Resources and references

The formulas and methods in this calculator were checked against these independent sources.