Question

What is the Taylor Rule in AS/AD framework?

Answer 1

The Taylor Rule suggests that the Federal Reserve should raise rates when inflation is above target or when gross domestic product (GDP) growth is too high and above potential. It also suggests that the Fed should lower rates when inflation is below the target level or when GDP growth is too slow and below potential.

I=R∗+PI+0.5(PI−PI∗)+0.5(PI−PI∗)

where:I=Nominal fed funds rate , R∗=Real federal funds rate (usually 2%), PI=Rate of inflation, P∗=Target inflation rate, Y=Logarithm of real output, Y∗=Logarithm of potential output​