The Taylor Rule is a monetary policy guideline for central banks to set interest rates based on inflation and other economic indicators. The rule was named after its creator, economist John Taylor.

According to the Taylor Rule, the central bank should adjust the nominal interest rate by a certain amount in response to changes in inflation, output gap, and potential GDP. Specifically, the rule suggests that the central bank should increase interest rates when inflation rises above the target rate, or when the output gap narrows, and should decrease interest rates when inflation falls below the target rate, or when the output gap widens.

The Taylor Rule is widely used in the field of macroeconomics as a benchmark for evaluating central bank policy. However, it is important to note that the rule is not a precise formula, and central banks may use their discretion in adjusting interest rates based on their own assessment of the economic situation.

The original version of the Taylor Rule was proposed by John Taylor in a 1993 paper titled "Discretion Versus Policy Rules in Practice." The rule can be expressed as follows:

Nominal interest rate = neutral interest rate + 0.5(inflation rate - target inflation rate) + 0.5(output gap)

In this version of the rule, the central bank adjusts the nominal interest rate based on two factors: the deviation of actual inflation from the target inflation rate, and the output gap, which is the difference between actual GDP and potential GDP. The neutral interest rate is the level of interest rates that would prevail if the economy were at full employment and inflation were at its target level.

The coefficients on inflation and the output gap, 0.5 each in this version of the rule, reflect the extent to which the central bank responds to these variables. The higher the coefficients, the more aggressive the central bank is in responding to changes in inflation and the output gap.

The Fed then sets the employments and inflation as their targets.