Instrument rules vs targeting rules? Should Central Banks commit to a simple instrument rule such as the Taylor Rule? How well does such a rule explain Central Bank behaviour? Do targeting rules provide a more compelling alternative?

The Taylor rule has had a wide-reaching effect on the literature surrounding monetary policy design. It is a simple instrument rule which aims to show how interest rates should respond to two economic indicators: Inflation and Output. This simple rule has led to the “Taylor Principle” which has been said to be useful in guiding policy design. Many studies have been done to determine whether or not the Taylor rule appears to guide monetary policy in many central banks. However there has been a vocal group that criticises the Taylor Rule and instrument rules in general as being inflexible and not allowing for discretionary measures, this has sparked lively debate between the two sides of the debate. This essay will examine the literature surrounding the Taylor Rule and analyse the good and bad aspects of the rule. In addition to this the empirical studies examining the Taylor Rule will be discussed. Furthermore a brief look targeting rules will provide a useful counterpoint to the analysis of instrument rules.

Literature surrounding the Taylor Rule

Before discussion of the literature surrounding the Taylor Rule can begin it is necessary to define what Central banks aim to achieve with monetary policy. Most agree that inflation targeting is a key concern for central banks with the aim being to keep it at a low and stable level. In addition to this there are concerns for keeping a stable level of output which should aim to keep it at a level around potential output and for general control of monetary aggregates such as money supply. With these objectives in place the Taylor rule can now be examined in how it allows central banks to follow a simple rule to meet its objective.

The Taylor rule is a simple instrument rule which shows that interest rates should be determined by the inflation gap and the output gap as shown in this equation:

 (Walsh, 2003, p.546)

The  and  coefficients are both >0. This being added to the real interest rates leads to the Taylor principle which states that a deviation from the target rate of inflation should be met with a larger than one to one change in the nominal rate of interest. This is called the “Taylor Principle” and the empirical literature surrounding central bank behaviour aims to find evidence of the Taylor Principle adhered to by Central Banks.

Bernanke (2004) describes the above equation as a simple feedback policy due to the central bank reacting to feedback from the economy on a number of variables that can be estimated at the time and don’t rely on forecasting. As the literature around the Taylor rule has grown so too has the variations of the model which have included both lagged variables and forecasting (Clarinda, et al.) It has also been adapted to provide guidelines for a variety of monetary policy regimes as Orphanides (2007, p.15) has pointed out two examples; one being a money growth regime and the other an inflation targeting regime. The Taylor Rule and the principle which follows on from it serve as a good starting point for monetary policy making due to its simplicity allowing a variety of variations of it to suit a variety of needs and thus serves a useful benchmark.

Its simplicity provides a host of other benefits well. Firstly its ability to relate policy to the state of economy by showing how interest rates, inflation and output interact with each other it provides a good guideline for central banks to follow. In addition to if a central bank can commit to such a rule it will provide a baseline for expectations regarding future monetary policy for financial markets and other private agents.