How the Taylor rule works
In “Discretion versus Policy Rules in Practice” (Carnegie-Rochester Conference Series, 1993), John Taylor made a striking observation: a formula simple enough to fit on one line described the federal funds rate the Greenspan Fed had actually chosen from 1987 through 1992 with surprising accuracy. The rule was never meant as an autopilot — Taylor himself stressed judgment — but it gave everyone a common yardstick. When commentators say policy is “behind the curve” or “too tight,” a Taylor-rule gap is usually the arithmetic behind the claim, and the Federal Reserve itself publishes the prescriptions of several rule variants in its semiannual Monetary Policy Report.
The Taylor rule (1993)
i = r* + π + a(π − π*) + b(gap)
where i is the prescribed nominal policy rate, r*the equilibrium real interest rate, π current inflation,π* the inflation target, and gap the output gap — the percent by which real GDP exceeds (positive) or falls short of (negative) potential. Taylor’s original parameters, this calculator’s defaults, are r* = 2, π* = 2, and a = b = 0.5. Because inflation enters both on its own and through the gap term, the rule raises the nominal rate more than one-for-one with inflation — the Taylor principle that makes the real rate rise when prices accelerate.
Worked example
Take an economy with inflation at 3.00% against a 2.00% target, output 1% below potential, and Taylor's original parameters. The rule builds its prescription term by term:
| Step | Amount |
|---|---|
| Equilibrium real rate r*Taylor’s 1993 assumption for the real rate consistent with full employment | +2.00 pp |
| Current inflation πadded in full so the rule sets a real, not just nominal, response | +3.00 pp |
| Inflation-gap term a(π − π*) = 0.5 × 1inflation of 3.00% runs 1 pp above the 2.00% target | +0.50 pp |
| Output-gap term b(gap) = 0.5 × (-1)output 1% below potential argues for a slightly easier stance | −0.50 pp |
| = Prescribed policy rate ivs an actual rate of 4.50%, the rule sits +0.50 pp — policy is a touch easier than the formula | 5.00% |
Computed with this calculator's default settings — open the tool above and you'll see the same numbers, then swap in current inflation and output-gap estimates.
A benchmark, not a mandate
Each term of the rule has a job. The first two — r* plus current inflation — reconstruct the neutral nominal rate at which policy neither stimulates nor restrains. The inflation-gap term leans against prices running above target; the output-gap term leans against slack or overheating in the real economy. The rule’s weak points are just as instructive: r* is unobservable and must be estimated, the output gap is revised for years after the fact, and in deep recessions the formula prescribes negative rates that the zero lower bound makes impossible — the situation the Fed faced after 2008, when the rule called for a funds rate several points below zero and policy turned to asset purchases instead. Used with those caveats, it remains the most widely quoted single benchmark in monetary policy.
The rule’s inputs connect to tools of their own: see how inflation splits nominal from real interest rates with theFisher equation calculator, measure price changes over time with theinflation calculator, or work out the growth side of the output gap with theGDP growth rate calculator.
Frequently asked questions
What is the Taylor rule?
The Taylor rule is a simple formula, proposed by Stanford economist John Taylor in 1993, that translates two numbers — how far inflation sits from its target and how far output sits from its potential — into a suggested setting for the central bank’s policy interest rate. It starts from a neutral rate (the equilibrium real rate plus current inflation) and adjusts up when inflation runs hot or the economy overheats, and down in the opposite cases. Taylor showed the formula tracked actual Federal Reserve decisions from 1987 to 1992 remarkably well, which made it the standard benchmark for judging whether policy looks tight or easy.
What do the coefficients a and b mean?
They are the weights the rule places on its two gaps. Coefficient a says how many extra percentage points of policy rate the rule adds for each point of inflation above target; b does the same for each point of output above potential. Taylor set both to 0.5. Crucially, because current inflation also enters the formula on its own, the total response to inflation is 1 + a — more than one-for-one. That property, called the Taylor principle, ensures the real interest rate rises when inflation rises, which is what actually cools an economy. A larger b describes a central bank that fights recessions more aggressively.
Does the Federal Reserve actually follow the Taylor rule?
No — the rule is a benchmark, not a mandate. The FOMC sets rates by committee judgment, weighing financial conditions, employment data, global risks, and much else that two gaps cannot capture. That said, the Fed takes rules seriously: its semiannual Monetary Policy Report includes a section comparing the actual federal funds rate with the prescriptions of the Taylor rule and several variants. Historically the fit has varied — the rule tracked policy closely in the Greenspan era of the late 1980s and 1990s, prescribed negative rates policy could not deliver after 2008, and called for hikes well before the Fed moved in 2021–22.
What is r*, and why is it controversial?
r* (the equilibrium or natural real interest rate) is the inflation-adjusted rate consistent with the economy at full employment and stable inflation — the level at which policy is neither stimulating nor restraining. Taylor simply assumed 2%. The problem is that r* cannot be observed; it must be estimated from models, and estimates disagree and shift over time. Many economists argued r* fell well below 2% after the 2008 financial crisis, which alone changes the rule’s prescription point-for-point. This unobservability is one of the main practical criticisms of using any rule mechanically.
What happens when the rule prescribes a negative rate?
A central bank cannot push its policy rate meaningfully below zero, because cash always pays exactly zero — this constraint is the zero lower bound. In a deep recession the Taylor rule can prescribe a clearly negative rate: with inflation at 1% and output 6% below potential, the 1993 parameters call for −0.5%. When that happens the rule is signalling that conventional rate cuts are exhausted, which is why central banks turned to unconventional tools — large-scale asset purchases and forward guidance — after 2008. This calculator flags any prescription below zero rather than clipping it, so you can see how far past the bound the formula goes.
Disclaimer: This calculator is foreducation and illustration only. The Taylor rule is a stylized benchmark built on unobservable quantities — r* and the output gap are model estimates that get revised — and no central bank sets policy by formula. Results are a textbook calculation, not a policy forecast, and nothing here is investment or financial advice.