University of St. Andrews (Scotland)

Course: Monetary Policy (EC 3124)

Explain carefully the rationale for the Taylor rule in monetary
 policy and discuss the extent to which modern central banks in major 
countries have been following Taylor rules

by

Kristian Kanthak

1. Introduction 2

2. Why do we need Simple Monetary Policy Rules? 3
2.1 Economic Principles 3
2.2 Advantages of Simple Monetary Policy Rules 4

3. The Taylor rule 4

4. To which extent have modern central banks been following Taylor Rules? 6
4.1 Monetary Policy in Japan, the U.S. and in Germany 7
4.2 Monetary Policy in the U.K. 7

5. Conclusion 8

6. References 8

1. Introduction

According to Goodhart′s speech in 1998, the key decision that the monetary authorities take each month is whether, and by how much, to alter the short- term interest rate. As central banks vary interest rates in response to economic development the crucial question has become how they should adjust it in order to achieve, or to come as close as possible to, the social welfare optimum. The vital importance of this decision for the financial community and therefore the economies in general could be observed in the public discussion which frequently occurs about how the Fed and the ECB should react by changing the short term interest rates.

A popular way of explaining the way central banks take its interest rate decisions has been proposed by Taylor in 1993. He basically suggested a rule, which he derived from observation of former successful monetary policy. This essay shows how the Taylor rule works and to which extent major central banks have been following the rule.
The first chapter of this essay briefly explains the rationale and advantages of simple monetary policy rules. The second chapter focuses on the Taylor rule itself and explains the way it works by referring to the preceding chapter.
Finally the last chapter discusses the work of the central banks in the last decades.

2. Why do we need Simple Monetary Policy Rules?

In 1990 Taylor started promoting the use of simple monetary policy rules in the setting of interest rates by the Fed. He pointed out several advantages, which their use would provide. The consideration of his argumentation helps to understand the notions and the complex mechanisms behind his famous rule. Therefore the next chapter focuses on these basic ideas from which the rule originated.

2.1 Economic Principles

Taylor took five economic principles as a starting- point for his work (see Taylor 1998). He assumed that there was a general consensus about these "key macroeconomic principles". From the following principles he derived implications and recommendations for monetary policy.

[...]