Setting the Rate

A Rule You Should Not Follow

Drive the Taylor rule yourself, then find the three places where doing what it says would be a mistake.

12 min135 XP available4 challenges

Run the model

Set the rate the way the rule would.

i = r* + π + 0.5(π − target) + 0.5(output gap). The target is 2%. Inflation above it raises the rate by more than one-for-one, which is the whole point — the real rate has to rise, or inflation feeds itself. The output gap is how far production is above or below what the economy can sustain. Watch the stance readout: it is the part of the prescription that is not simply tracking inflation.

Rate the rule prescribes

2.5%

r* + π + 0.5(π − target) + 0.5(gap)

What you can actually set: 2.5%
Stance: 0%

Inflation now2%

The euro area touched 10.6% in October 2022

Output gap0%

Negative means the economy is producing less than it could

Neutral real rate (r*)0.5%

Estimated, never observed — move it and watch everything shift

Reach a deflationary slump where the rule asks for a rate below zero

Try 9% — not yet
Reach a deflationary slump where the rule asks for a rate below zero — not yet

Answer to continue.