First, write out the equation that represents the Taylor rule. Second, discuss how the Taylor rule is used to explain the implementation of monetary policy.

What will be an ideal response?

ANSWER:

The Taylor rule is represented as the following: i = i* + a(π – π*) – b(u – un). i* is the target interest rate and π* is the desired inflation rate. Two quick cases can be examined. If actual inflation is greater than π*, the central bank should raise the interest rate above the target rate. This will reduce economic activity and reduce the actual inflation rate over time. If the unemployment rate is above the natural rate, the central bank should set the interest rate below the target rate in order to stimulate economic activity.