Question

how is the taylor's rule effextigr in guiding monetary policy - changing the policy interest rate

Answer 1

The Taylor rule is the guiding principle for monetary policy all over the world. Most of the central banks follow a version of the Taylor rule in setting their interest rates, either explicitly or tacitly.

The basic intuition behind the Taylor rule is that the central banks should increase the rates when the real output exceeds the potential output or when the inflation is higher than the target rate and vice versa.

the formula can be given as follows:

i = p + ay + b(p – 2) + r_t

where we have

i = federal funds rate

p = rate of inflation

y = the percent deviation of real GDP from a target

r is the equilibrium real interest rate

Based on the values of a and b (depends on the central bank objectives and the state of the economy), the bank knows the weight it gives to excess inflation and a recessionary gap, the tradeoff. Thus, it gives a simple equation that can be followed to set rates consistently. Empirical evidence suggests that for many countries a value fo a and b can be found, such that the Taylor rule very closely predicts the movements in the interest rates.