The Taylor Rule: Is It a Useful Guide to Understanding Monetary Policy?

Abstract

According to the Taylor rule, the Federal Reserve sets the funds rate based on an estimate of the economy’s unutilized resources and the contemporaneous behavior of inflation. The primary policy prescription deriving from this view is that the Fed has failed to control inflation when it has not responded vigorously enough to observed inflation. However, there are reasons to question this understanding of how the Fed controls inflation. If the Fed creates inflation, it is better to pursue a monetary policy that prevents inflation rather than responds to it.