The Taylor Rule: A Guidepost for Monetary Policy?

1. Define the following terms used in the reading:
   1. "natural" real federal funds interest rate
   2. "neutral" monetary policy
   3. "lean against the wind"
   4. Taylor principle
   5. inflationary spiral
   6. credibility

2. What are the arguments in favor of using rules in policymaking? Why do policymakers generally oppose them?

3. What are the four components of the Taylor rule? What simplifying assumptions did Taylor make to facilitate use of the rule?

4. According to the Taylor principle, how should the Fed react to an increase in the inflation rate? Why?

5. How should the Fed react to a deviation of output growth from its target rate? Why?

6. Why did monetary policy in the latter 1990s and early 2000s vary from the predictions based on the Taylor rule?

7. Explain how using the Taylor rule as a guideline can enhance policymakers' credibility and why this is important.

Source: "The Taylor Rule: A Guidepost for Monetary Policy?" Charles T. Carlstrom and Timothy S. Fuerst, Federal Reserve Bank of Cleveland Economic Commentary, July 2003, pp. 1-3.