Question

24. If Japan had followed a Taylor Rule during the 1990s, would they have avoided their “lost decade”?

Answer 1

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Introduction

The Taylor Rule is an interest rate forecasting model invented by famed economist John Taylor in 1992 and outlined in his 1993 study, "Discretion Versus Policy Rules in Practice." It suggests how central banks should change interest rates to account for inflation and other economic conditions.

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.

Reason Behind Japan to avoid their lost decade in response to Taylor Ruleduring the 1990's

• The Taylor rule guides how central banks should alter interest rates due to changes in the economy.
• Taylor's rule was created to adjust and set prudent rates for the short-term stabilization of the economy while maintaining long-term growth.
• Taylor's rule recommends that the Federal Reserve should raise interest rates when inflation is high or when employment levels are high.
• Critics believe that the Taylor principle cannot account for sudden jolts in the economy.

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