Monetary policy/Addendum

The Taylor Rule

The rule states that the real short-term interest rate (that is, the interest rate adjusted for inflation) should be determined according to three factors:

(1) where actual inflation is relative to the targeted level that the Fed wishes to achieve;

(2) how far economic activity is above or below its "full employment" level; and,

(3) what the level of the short-term interest rate is that would be consistent with full employment.

The rule recommends a relatively high interest rate (that is, a "tight" monetary policy) when inflation is above its target or when the economy is above its full employment level, and a relatively low interest rate ("easy" monetary policy) in the opposite situations.