More on Interest Rates

Taylor explained the rule of determining interest rates using three variables: inflation rate, GDP growth, and the real interest rate.

Learning Objectives

Describe how the nominal interest rate is influenced by inflation, output, and other economic conditions

Key Takeaways

Key Points

• In economics, the Taylor rule is a monetary-policy rule that stipulates how much the Central Bank should change the nominal interest rate in response to changes in inflation, output, or other economic conditions.
• If the inflationary expectation goes up, then so does the market interest rate and vice versa.
• If output gap is positive, it is called an "inflationary gap," possibly creating inflation, signaling a increase in interest rates made by the Central Bank; if output gap is negative, it is called a "recessionary gap," possibly signifying deflation and a reduction in interest rates.

Key Terms

• inflationary gap: An inflationary gap, in economics, is the amount by which the real gross domestic product, or real GDP, exceeds potential GDP.
• Real interest rate: The "real interest rate" is the rate of interest an investor expects to receive after allowing for inflation. It can be described more formally by the Fisher equation, which states that the real interest rate is approximately the nominal interest rate minus the inflation rate.
• Recessionary gap: An inflationary gap, in economics, is the amount by which the real Gross domestic product, or real GDP, is less than the potential GDP.