Question

What is meant by a Taylor rule? Describe rule based monetary policy, and the pros and cons of such an approach?

Then describe how the Taylor rule approach affects central bank credibility

Answer 1

Taylor rule is the approximation of responsivenes of nominal interest rate set by the central bank to changes in inflation and output. The rule describes how for each one percent increase in inflation central bank raises nominal interest rate by more than one percent. It suggests that federal reserve should raise nominal rates when Inflation is more than target inflation rate or when Gross domestic product is too high.

Since the Rule is based on the inflation rate and output gap measured over a duration of time it cannot correct sudden jolts in the Economy. Also the determination of interest rate requires the variables to be known which are not observable and should be calculated from other information.