More on Interest Rates

The GDP gap or the output gap is (y_t – y*_t). If this calculation yields a positive number, it is called an "inflationary gap" and indicates the growth of aggregate demand is outpacing the growth of aggregate supply (or high level of employment), possibly creating inflation, signaling an increase in interest rates made by the Central Bank; if the calculation yields a negative number it is called a "recessionary gap," which is accompanied by a low employment rate, possibly signifying deflation and a reduction in interest rates.

In this equation, both α_π and α_y should be positive (as a rough rule of thumb, Taylor's 1993 paper proposed setting α_π =α_y = 0.5). That is, the rule "recommends" a relatively high interest rate (a "tight" monetary policy) when inflation is above its target or when output is above its full-employment level, in order to reduce inflationary pressure. It recommends a relatively low interest rate ("easy" monetary policy) in the opposite situation to stimulate output.

Taylor explained the rule in simple terms using three variables: inflation rate, GDP growth, and the equilibrium real interest rate.