A Simple Explanation of the Taylor Rule?

Abstract

The modern New Keynesian literature discusses the stabilising properties of Taylor-type interest rate rules mainly in the context of complex optimising models. In this paper we present a simple alternative approach to provide a theoretical rationale for the adoption of the Taylor rule by central banks. We find that the Taylor rule can be derived as the optimal interest rate rule in a classical Barro-Gordon macroeconomic model. The successful practice of central bankers, at the core of the Great Moderation, and currently re-invoked to re-normalise monetary policy after the unprecedented quantitative-easing actions aimed to escape the Great Recession, can perfectly be explained by standard theory, without recourse to more complicated derivations.