The Taylor rule recommends adjusting interest rates in response to inflation and the output gap.
American economist John B. Taylor proposed the rule in 1992 as a systematic guide for setting a short-term policy interest rate. In its original form, the recommended rate responds to the difference between actual inflation and the central bank’s target, as well as the difference between actual output and potential output.
When inflation rises above target or output exceeds its sustainable level, the rule generally calls for a higher interest rate to cool demand. When inflation is weak or output falls below potential, it points toward a lower rate to support economic activity. Taylor’s 1993 formulation commonly used coefficients of 0.5 for both the inflation gap and output gap.
The Taylor rule is a benchmark, not an automatic law followed mechanically by every central bank. Policymakers may also consider financial stress, exchange rates, supply shocks, employment, and changing estimates of potential output. It is distinct from the Friedman rule, which concerns the optimal money-supply or nominal-interest setting, and from the Fisher relation, which links nominal and real interest rates.