The interest-rate rule that describes (and prescribes) how central banks respond to inflation and gaps.
Warming up the engine…
A simple formula describing how central banks set interest rates: respond to inflation above target and output above potential, and move the nominal rate MORE than one-for-one with inflation.
i = r* + π + 0.5(π − π*) + 0.5(y − y*)
The more-than-one-for-one response (the Taylor principle) is the crucial part: if inflation rises 1% and the nominal rate rises only 0.5%, the REAL rate falls and policy accidentally stimulates an overheating economy. Central banks that violated the principle (the 1970s Fed) got spiralling inflation; those that follow it anchor expectations.
Check the coefficient on inflation: stability requires it to exceed 1 in nominal terms. Plugging numbers into the rule and comparing with the actual cash rate is a common data question.
Now prove you have it
Move the curve to where you think it lands, and get told exactly which part you got right.
Real-world scenarios on this model
Equilibrium at π 3.0, i 5.5.
Equilibrium: π* = 3.0, i* = 5.5
Current equations
A one-line description of what central banks do: start from the neutral rate, add inflationinflationA sustained rise in the overall price level, eroding money's purchasing power., and push harder when inflation strays from target. The line's steepness. 1.5, not 1, is the whole secret.
Source: Taylor (1993); Blanchard ch. 23