Home > Development Economics, Interest Rates > Emerging Economies need to follow Taylor Rule.

Emerging Economies need to follow Taylor Rule.

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.” It is named after Stanford economist John B. Taylor. Source: Wikipedia

The Credit Writedowns site had an interesting article stating that interest rates in emerging markets were far too low and were well below the rate outlined in the Taylor Rule. According to the Taylor rule, for each 1% increase in inflation, a central bank should raise the nominal interest rate by more than 1%. While the Federal Reserve never operated according to a strict Taylor rule, many thought of it as a guideline which did influence Fed thinking. But in the wake of the financial crisis, no one is paying any attention to the Taylor Rule. They mention a report by the World Bank which addresses the issue of monetary policy in emerging markets.

The “imported” easing of monetary conditions through large capital inflows in recent years has contributed to rapid credit expansion, widening current account deficits, and increasing banking sector vulnerabilities in some cases.

The surge of capital flows in the post-crisis period has contributed to lenient domestic credit conditions, directly through cross-border intermediation channels and indirectly through exchange rate and monetary policy spillovers. Regarding the latter, a simple Taylor Rule predicting the monetary policy stance of central banks in developing countries on the basis of domestic conditions (deviation of consumer price inflation from the policy target and the level of slack in the economy) suggests that policy rates were kept lower than normally suggested during periods of large capital inflows (figure B3.7.1 and He & McCauley (2013))
Taylor Rule

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