Central-bank interest rate: the short-term rate set by the central bank. Raising it tends to make mortgages and business borrowing more expensive, weakening spending and investment. That can reduce demand-driven inflation — but can also cost output and jobs.
INFLATION6.2%Prices are rising quickly.
UNEMPLOYMENT4.1%Share of workers seeking work.
CENTRAL-BANK RATE3.0%The rate you control.
BUSINESS LOAN RATE6.0%What firms actually pay to borrow.
How hard do you squeeze demand?
5.00%
The trade-off: too little tightening → inflation may persist. Too much → loans become dearer, investment weakens and unemployment can rise.
CONSEQUENCES · YOUR RATE REACHES FINANCE
INFLATIONHow quickly prices are rising.
UNEMPLOYMENTThe labour-market cost.
BUSINESS LOAN RATEWhat firms pay banks to borrow.
SHARE PRICESMarket value of company shares.
WHY DO BUSINESS LOANS MOVE?
Changes in the central-bank rate and its expected future path feed into banks' funding and market rates, so lending rates often adjust too. Higher loan rates make borrowing to invest more expensive.
WHY CAN SHARE PRICES FALL?
Higher market interest rates can raise the discount rates investors apply to future cash flows. Other things equal, that lowers their present value and can put downward pressure on share prices.
Inflation has reacted — but unemployment is now hurting. Do you change course?
4.50%
REPUTATION · MARKETS WATCH WHAT YOU DO
Your decision tells investors something about how you react under pressure.
ECONOMY CHANGES→YOU RESPOND→INVESTORS GUESS WHAT YOU'LL DO NEXT
REPUTATION
Not popularity. It means the pattern investors think they can see in your decisions — for example, whether you prioritise inflation or unemployment when they conflict.
WHY FINANCE CARES
Investors buy and sell assets today based partly on where they think interest rates will go tomorrow. So your expected future behaviour can affect today's financial prices.
Next: unemployment jumps again. You do not get to act first. Investors will move money based on what they think you are about to do.
THE BET · FINANCE MOVES BEFORE YOU DO
Unemployment jumps to 8%. Markets move before your next decision.
YOUR CURRENT RATEThe central-bank rate you set last round.
INVESTORS EXPECT NEXTThe move they think you will make now.
10-YEAR GOVT BOND YIELDReturn demanded to lend to government for 10 years.
EXPECTED INFLATIONWhat investors expect inflation to be.
WHY HAS THE 10-YEAR YIELD MOVED?
You set today's short-term central-bank rate, not the 10-year yield. Investors set the yield by buying and selling government bonds. Its yield reflects the expected path of future short-term rates plus a term premium for holding longer-maturity debt. So expectations about your future policy matter, but they are not the only force moving the 10-year yield.
WHY SHOULD YOU CARE?
Government bond yields are important reference rates for longer-term finance. Private borrowing rates also contain credit, liquidity and other premia. So a change in expected future policy rates can alter wider financial conditions before the central bank actually changes today's rate.
Investors have made their bet. Now set the rate they were trying to predict.
4.00%
This is the actual interest rate you are setting now. Compare it with the market expectation above.
REPRICING · WERE INVESTORS RIGHT?
INVESTORS EXPECTEDThe rate move priced in beforehand.
YOU ACTUALLY CHOSEYour new central-bank rate.
FORECAST RESULTWere expectations close?
PRICED IN
If investors expect a rate move, they can buy and sell assets before it happens. The expected policy path is therefore already reflected partly in market prices.
REPRICING
If your actual decision differs from what markets expected, bond yields and asset prices adjust to the new information. That adjustment is repricing.
DISCRETION
THAT WAS DISCRETION.
You decided the appropriate rate case by case after each shock. No previously announced reaction function determined your response.
The attraction: flexibility. The problem: markets must forecast the policymaker too.
Expected future central-bank rates feed into bond yields. Those yields influence business borrowing costs and the discount rates investors use to value future cash flows.
BUILD · STOP MAKING MARKETS GUESS
Can you replace “trust me” with a predictable reaction?
Reset the economy. Inflation is at its 2% target, output is at its sustainable level, and the central-bank interest rate is 4%.
UNDER DISCRETION
A shock arrives. You decide what to do after seeing it. Markets must guess how you will react.
YOUR NEW IDEA
Announce in advance how the interest rate will normally react to economic conditions. Markets can then calculate the normal response.
Don't build the whole rule yet. We will construct it one piece at a time. Each new economy will expose something the previous version cannot do.
PART 1 · INFLATION RESPONSE
Inflation rises 1pp. How much should your interest rate rise?
Starting point: inflation 2%, central-bank rate 4%. Imagine inflation rises to 3%. Choose the reaction you would promise in advance.
+1.0pp
WHY THIS CHOICE?
Higher interest rates make borrowing and spending less attractive. But inflation also changes the real cost of borrowing.
WHAT TEST 1 WILL DISCOVER
Is merely raising the quoted interest rate enough — or must it rise by a particular amount to actually tighten monetary policy?
TEST 1 · WHY MORE THAN ONE-FOR-ONE?
Purpose: discover how strongly the interest rate must respond to inflation if policy is genuinely to become tighter.
Discovery: a stabilising Taylor-type rule responds more than one-for-one to a rise in inflation. In this simple example, where expected inflation rises with the inflation shock, that also raises the approximate real policy rate. This is the Taylor principle.
TEST 2 · YOUR INFLATION RULE JUST FAILED
Inflation is fine. The economy has slumped.
Inflation is still exactly 2%, so your inflation rule says: NO RATE CHANGE. But output is now 3% below its sustainable level and unemployment is rising.
YOUR RULE HAS NOTHING TO SAY.
WHY?
You built a rule that reacts only to inflation. With inflation on target, its prescribed adjustment is zero — even though demand is weak.
WHAT IS MISSING?
The rule needs a second instruction telling interest rates how to react when actual real GDP falls below estimated potential GDP. The percentage difference between them is the output gap.
Purpose of Test 2: not to test another coefficient. It exposes why an inflation-only rule is incomplete.
PART 2 · ADD THE OUTPUT RESPONSE
How strongly should rates support a weak economy?
Suppose real GDP is 1% below estimated potential GDP while inflation remains on target. Choose the rate cut your rule will promise.
−0.5pp
WHY CUT?
Lower central-bank rates and expectations of lower future rates tend to ease wider financial conditions. That can reduce some borrowing rates and support household spending and business investment when demand is weak.
NO MAGIC NUMBER
A larger response gives more stabilisation, but makes policy react more strongly to an output gap that economists can only estimate.
Your rule now has two parts: one fights inflation; one supports weak output. Time to make them collide.
TEST 3 · THE TWO RESPONSES COLLIDE
Inflation says RAISE. Weak output says CUT.
Purpose: discover what a systematic rule can — and cannot — solve. Inflation is 4% (+2pp above target), while output is 2% below potential.
YOUR INFLATION RESPONSERATE UP
+
YOUR OUTPUT RESPONSERATE DOWN
THE RULE MAKES YOUR REACTION PREDICTABLE. IT DOESN'T MAKE THE CONFLICT DISAPPEAR.
REVEAL · MACHINERY EXPOSED
YOU BUILT THE LOGIC OF A TAYLOR-TYPE RULE.
YOUR RULE HAD TWO INSTRUCTIONS
INFLATION RISES → Raise the central-bank rate strongly enough to tighten policy.
ECONOMY WEAKENS → Cut the central-bank rate to support demand.
TAYLOR'S FAMOUS BENCHMARK
Start from 4% when inflation is at its 2% target and output is at potential.
WHY MARKETS CARE: the next shock is still uncertain, but the central bank's normal reaction is less mysterious. That helps investors form expectations about future short-term rates — which feed into longer-term yields and wider financial conditions.
The symbols are simply shorthand for the mechanism you have just built. In Taylor's original illustrative calibration, the neutral real rate and inflation target were both 2%, giving a 4% nominal rate when inflation is on target and the output gap is zero.
VERDICT: systematic rules can make policy more predictable and support credibility. They do not abolish judgement: potential output and the neutral real rate are estimated, financial transmission is uncertain, and stagflation can make the objectives pull in opposite directions.