Taylor Rule
Plain definition
A monetary-policy guideline stating how a central bank should set its short-term interest rate based on inflation and economic activity: the Taylor Rule raises the policy rate when inflation exceeds its target or output exceeds its potential, and lowers it when conditions are below target.
In economics
Economists use the Taylor Rule as a benchmark for judging whether actual policy is 'too loose' or 'too tight.' The standard form is: policy rate = r + pi + 0.5(pi - pi) + 0.5(output gap), where r is the neutral real rate and pi is the inflation target. It is a rule-of-thumb, not a law -- central banks also weigh financial stability and data uncertainty.
Example
If inflation runs at 4% against a 2% target while the output gap is zero, the Taylor Rule prescribes a nominal rate of roughly 2% neutral real + 4% inflation + 1% inflation gap = about 7%, telling policymakers rates should be well above the current level.
A common mix-up is treating the Taylor Rule as a binding formula central banks follow mechanically. In reality it is a descriptive benchmark economists use to evaluate decisions; actual policy committees use it as one input among many, alongside judgment about risks and uncertainty.