# Taylor Rule - Relationships between GDP and Inflation

This is referring to the 2009 Mock Q5) B) ii)

Roptimal = 3.5 + [0.5 x (0.3 – 2.2) + 0.5 x (4.4 – 2.0)] = 3.75%

Rcurrent = 5.5%

“The Taylor rule suggests the Bank of England should target a short-term interest rate of 3.75% versus a current short-term interest rate of 5.5%. The most likely potential negative economic result of the Bank of England following the Taylor rule is increased inflation. Since the forecast inflation rate of 4.4% is currently above the target inflation rate of 2.0%, a cut in the interest rate could cause the inflation rate to rise even further away from the target inflation rate. Lowering short-term rates will stimulate output by lowering corporations’ cost of capital.”

Can someone explain to me why decreasing the target rate will further increase inflation?  This is due to the fact that inflation forecast is above trend but GDP forecast is below trend.

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Money supply increase

Don't forget to carry the one.

lower rates means more money supply and everyone borrows more, supposedly leading to more economic activity and finally, inflation picking up.

Ah I see. Totally blanked out.  Thanks for the reminder!

Circling back on this topic…do you compare the implied optimal rate (from Taylor rule calc) to the neutral short-term rate or the current short-term interest rate? The examples in the CFAI curriculum appear to compare the implied rate to the neutral rate?

taylor’s rule is deciding the short-term interest rate based on inflation and GDP expectations and target and uses neutral rate as the base.

so yes, use neutral rate as base to find the short-term interest rate that would meet GDP and inflation target.

Edbert–apologies for the confusion; understand the neutral rate is used in determining the short-term IR (implied Taylor Rule) rate, but what is that rate then compared against in determining whether or not rates should be increased / decreased?

The above example compares the implied TR rate (3.75%) to the current rate of 5.5%, but I’ve seen questions compare the TR rate to the short-term neutral rate (given above as 3.5%) as well, which would provide a different response / effect to the expected rate change.

the TR rate is compared with forecasts and targets of GDP and inflation rate.

in example above, let’s say we assume the bank does follow the TR but it doesn’t match either of our calculations. so, either our forecasts are misaligned with the bank’s or the bank has a lower target of inflation or GDP growth.

on the other hand, if we assume that our forecasts are in line with the bank’s and the bank has not changed the inflation and GDP growth targets, then we can infer that the bank is not following TR or the bank is using TR but adding some kind of other consideration to it (maybe politics, maybe currency stability, etc)