Farhan Siddiq Tahir/ A-16U00535

Assignment

Intro to Capital Market

Q1: Taylor’s rule

Taylor rule came up as a solution to target interest rate determination in monetary policy. The Taylor rule is an
interest rate forecasting model invented and perfected by famed economist John Taylor in 1992 and outlined in
his landmark 1993 study, "Discretion Vs. Policy Rules in Practice."

Taylor operated in the early 1990s with credible assumptions that the Federal Reserve determined future
interest rates based on the rational expectations theory of macroeconomics. This is a backward-looking model
that assumes if workers, consumers and firms have positive expectations for the future of the economy,
interest rates don't need an adjustment. The problem with this model is not only that it is backward-looking, but
it also doesn't take into account long-term economic prospects.

Q2: Is Taylor’s rule important for Pakistan.

Basically it would help economy of Pakistan by identifying the nominal target interest rate (Fed Rate) and it will
help the monetary policy to balance inflation and unemployment rate which would also include GDP. Taylor
rule is important for Pakistan because normally, the Fed’s “target” for real GDP is potential output, the amount
the economy can sustainably produce when capital and labor are fully employed. With that assumption, the
variable y in the Taylor rule can be interpreted as the excess of actual GDP over potential output, also known
as the output gap. So Taylor rule can help Pakistan in calculating output gap. Secondly, it can also help
Pakistan’s economy in measuring inflation. It can also be used to see the responsiveness of the nominal
interest rate, as set by the central bank, to changes in inflation, output, or other economic conditions. It may
also help Pakistan to compare rates of inflation or non-inflation, and it will depict total picture of an economy in
terms of prices. It will also help in forecasting what interest rates will be, or should be, as shifts in the economy
occur. It also helps in evaluating tightness or ease of monetary policy. It is also important as it tells how policy
responds, quantitatively, to changes in inflation and the output gap.

Q3: Formula of Taylor’s rule

The formula used for the Taylor rule looks like this:

 i= r* + pi + 0.5 (pi-pi*) + 0.5 ( y-y*).

Where:

i = nominal fed funds rate

r* = real federal funds rate (usually 2%)
pi = rate of inflation
p* = target inflation rate
Y = logarithm of real output
y* = logarithm of potential output

What this equation says is the difference between a nominal and real interest rate is inflation. Real
interest rates are factored for inflation while nominal rates are not. Here we are looking at possible
targets of interest rates, but this can't be accomplished in isolation without looking at inflation. To
compare rates of inflation or non-inflation, one must look at the total picture of an economy in terms of
prices.
Relating Taylor’s rule to monetary policy:

Monetary policy is better at speeding up or slowing speed of economy. It works on idea that if Federal Reserve
increases the money supply what happens is that money will end up in bank and if bank has more money than
interest rate will be down. On the other hand, John Taylor very well-known economist came up with rule of
thought “Taylor rule”. As monetary policy targets inflation to balance inflation and unemployment. As GDP goes
lower unemployment goes higher. So they see target interest rate a.k.a Fed Fund Rate. If target interest rate
gets too low it will cause inflation. They can raise it or lower it by amount of money in monetary policy. So what
should be nominal target interest rate set? As they need to increase or decrease interest rate and its affect on
unemployment, GDP and inflation. So Taylor rule came up with approximate rule that set your target nominal
interest rate (fed fund rate) equal to inflation rate plus real interest rate plus. But something else also needs to
be added to speed up or slow down economy i.e. inflation gap and output. Inflation gap is What inflation is
what you like it to be. If inflation too low then your target interest rate should be lower too i.e. 0.5 of inflation
gap. Output gap would be % of GDP below potential and multiply it by 0.5.

So after looking at it as compared to monetary policy the advantages of nominal target interest are;

 The first benefit of looking at a simple rule like John’s is that it can provide a useful benchmark for
policymakers. It relates policy setting systematically to the state of the economy in a way that, over
time, will produce reasonably good outcomes on average.
 A second benefit of simple rules is that they help financial market participants form a baseline for
expectations regarding the future course of monetary policy.
 A third benefit is that simple rules can be helpful in the central bank’s communication with the general
public. Such an understanding is important for the transmission mechanism of monetary policy.

But if we compare it with monetary policy it has disadvantages too;

 The first disadvantage is that the use of a Taylor rule requires that a single measure of inflation be used
to obtain the rule prescriptions. The price index used by John in the Carnegie Rochester paper was the
GDP price deflator. Other researchers have used the inflation measure based on the consumer price
index (CPI). Over the past fifteen years, the Federal Reserve has emphasized the inflation rate as
measured by changes in the price index for personal consumption expenditures (PCE).
 Second, the implementation of the Taylor rule and other related rules requires determining the level of
the equilibrium real interest rate and the level of potential output; neither of them are observable
variables, and both must be inferred from other information.
 The third limitation of using simple rules for monetary policymaking stems from the fact that, by their
nature, simple rules involve only a small number of variables. However, the state of a complex
economy like that of the United States cannot be fully captured by any small set of summary statistics.
 The final limitation I want to highlight is that simple policy rules may not capture risk-management
considerations. In some circumstances, the risks to the outlook or the perceived costs of missing an
objective on a particular side may be sufficiently skewed that policymakers will choose to respond by
adjusting policy in a way that would not be justified solely by the current state of the economy or the
modal outlook for output and inflation gaps.