The Taylor Rule and Optimal Monetary Policy

where it denotes the Fed’s operating target for the federal funds rate, pt is the inflation rate (measured by the GDP deflator), yt is the log of real GDP, and y# t is the log of potential output (identified empirically with a linear trend). The rule has since been subject to considerable attention, both as an account of actual policy in the United States and elsewhere, and as a prescription for desirable policy. Taylor argues for the rule’s normative significance both on the basis of simulations and on the ground that it describes U.S. policy in a period in which monetary policy is widely judged to have been unusually successful (Taylor, 1999), suggesting that the rule is worth adopting as a principle of behavior. Here I wish to consider to what extent this prescription resembles the sort of policy that economic theory would recommend. I consider the question in the context of a simple, but widely used, optimizing model of the monetary transmission mechanism, which allows one to reach clear conclusions about economic welfare. The model is highly stylized but incorporates important features of more realistic models and allows me to make several points that are of more general validity. Out of concern for the robustness of the conclusions reached, the analysis here addresses only broad, qualitative features of the Taylor rule and attempts to identify features of a desirable policy rule that are likely to hold under a variety of model specifications.