We have prepared this Taylor rule calculator for you that calculates the federal funds rate. The Taylor rule depicts the relationship between the federal funds rate, the inflation rate and GDP (gross domestic product). It is a powerful econometric model that can help you to forecast federal funds rates.

After reading this article, you will understand what is Taylor rule and how to calculate the federal funds rate. Furthermore, you will find some practical Taylor rule examples to help you understand the econometric model better.

What is Taylor rule?

The Taylor rule, also known as Taylor's principle or the federal funds target rate formula, is one of the most proficient econometric tools that can help you to predict the federal funds rate. The Taylor rule definition was published by a Standard professor named John Taylor in 1993. In his study, he assumed the federal funds rate is closely related to 3 factors:

The Taylor rule is used to determine the ideal federal funds rate, in theory, that will lead the economy into stable prices and full employment, given the current situation. The tool implies that the Federal Reserve should raise the federal funds rate, or the short-term interest rate, when the inflation and employment rates are higher than the desired level. On the other hand, the short-term interest rate should be decreased to boost the economy if the inflation and employment rates are higher than the desired level.

Worry not if this Taylor rule definition sounds complicated. We have prepared some examples to show you how to find it.

How to calculate federal funds rate using Taylor rule? – Taylor rule calculator

Now, let's take a look at a Taylor rule example. Let's take Country A, with the following data, as an example:

  • Current inflation rate: 4%
  • Current GDP: $2,000,000,000
  • Long-run GDP: $3,000,000,000
  • Nominal interest rate: 5%
  1. Calculate the inflation rate gap.

The inflation rate gap is the difference between the current inflation rate and the desired inflation rate. For most advanced countries, the desired inflation rate will be 2%. As for the current inflation rate, you can get it from government-published data. For the US, you can find it on the US Bureau of Labor Statistics.

The inflation rate gap can be calculated as:

inflation rate gap = current inflation rate - desired inflation rate

The inflation rate gap for Country A is 4% - 2% = 2%.

  1. Calculate the output gap.

The output gap is defined as the deviation of GDP from the desired level. It can be calculated using the following formula:

output gap = log(current GDP) - log(long-run GDP)

where log is the common logarithm. For Country A, its output gap is:

log(2,000,000,000) - log(3,000,000,000) = 9.30 - 9.48 = -0.18%.

  1. Calculate the real interest rate.

The real interest rate is defined as the interest rate adjusted by the current inflation rate. The equation to calculate it is:

real interest rate = nominal interest rate - current inflation rate

In this example, the real interest rate will be 5% - 4% = 1%.

  1. Calculate the federal funds target rate using the Taylor rule formula.

Now it is time for us to calculate the federal funds target rate. The Taylor rule equation is:

federal funds target rate = real interest rate + current inflation rate + 0.5 * inflation rate gap + 0.5 * output gap

So plugging in the numbers from our example, thats:

1% + 4% + 0.5 * 2% + 0.5 * (-0.18%) = 5.91%.

Use our Taylor rule calculator to avoid all of these laborious computations!

What is the limitation of the Taylor rule formula?

Even though the Taylor rule equation can be a very powerful econometric tool, it does have its limitations:

  • The Taylor rule formula, or federal funds target rate formula, can provide little guidance during economic recessions. Economic recession often comes in the form of economic shocks that happen rapidly. As the Taylor rule focuses on predicting the federal funds rate using the deviation of the inflation rate and GDP from the long-term desired target, the Taylor rule does not consider sudden economic shocks.

  • The prediction obtained by calculating the Taylor rule equation could have little use when the GDP and the inflation rate go in different directions. The intricacies are not modeled into the Taylor rule calculation. This is particularly true when the economy is in stagflation, in which the GDP declines but the inflation rate rises. The Taylor rule can offer little help under these circumstances.

FAQ

What is the federal funds rate?

The federal funds rate is the interbank interest rate control by the Federal Reserve. It is the interest rate that one bank needs to pay to another when it borrows money from the bank. It is also known as the short-term interest rate.

What is inflation rate?

The inflation rate, also referred to as the Consumer Prices Index (CPI), is the increase in the prices of goods over time. For instance, if the annual inflation rate is 5%, it means that, on average, the prices of goods has increased 5% since last year. Governments tend to have a desired annual inflation rate of 2%.

What is GDP?

The gross domestic product, or GDP for short, is the monetary value of all the goods and services produced and delivered by a country. The higher the GDP, the larger the economy the country represents.

What is the real interest rate?

The real interest rate is defined as the difference between the nominal interest rate and the inflation rate. It is defined as the interest rate change given the inflation rate.

Wei Bin Loo
Inflation rate gap
Current inflation rate
%
Target inflation rate
%
Inflation rate gap
%
Output gap
Current GDP
$
Long-run GDP
$
Output gap
%
Real interest rate
Nominal interest rate
%
Real interest rate
%
Federal funds target rate
Federal funds target rate
%
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