Developed by John B. Taylor – aims to be a rule of thumb
If the Federal Reserve decides to increase the liquidity, it would then buy bonds and put more money into the market. As there is more money to lend, the interest rate would go down.
The monetary policy aims to target the inflation rate. Considering the Philips curve, there is a trade-off between unemployment and inflation. Unemployment could be replaced by its counterpart, economic growth. We consider the goal of the monetary department to balance GDP and Inflation.
The Fed normally has a target interest rate, the federal funds rate, which is the overnight rate in the interbank market for short term lending. How should the monetary policy set the target interest rate? This is the key discussion of the Taylor rule.
$$i=i^*+a (\pi – \pi^*) – b(U-U^*)$$
By the Philips curve, we replace unemployment with output. As we separate the interest rate to be the real interest rate and the inflation rate.
$$ i=r+\pi^*+a\underbrace{(\pi-\pi^*)}_{Inflation\ Gap}+b\underbrace{(Y-Y^*)}_{Output\ Gap} $$
The output gap could be considered to be by what percentage of the current GDP is below the Potential GDP.
Clearly, the Taylor rule is intuitively to be correct.
If there is an inflation gap the current inflation is greater than the target, which also means there is an extra money supply moving the CPI upward, then the Fed should conduct a contractionary monetary policy, and it should set a higher interest rate.
If the GDP growth is lower than the target (potential), or if the unemployment rate is greater than the target, then the Fed would like to stimulate the market. Thus, it would decrease the interest rate.
For the Taylor rule, John Taylor did not mean the monetary policy should follow it. It is not a law but just a rule of thumb. Normally, we also set the coefficients \(a\) and \(b\) to be 1\2. However, if we think the government would pay more attention to the inflation target, then we could certainly increase the weight of inflation gap.