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Inflation Targeting And Interest Rate Rules

932 words - 4 pages

A Project Report by:
November 23, 2015
Group #3
Section E
November 23, 2015
Group #3
Section E
Kaustubh (PGP/19/264)
Kavya (PGP/19/265)
Kunal (PGP/19/266)
Madhu (PGP/19/267)


Introduction ------------------------------------------------------------------------------------------------------ 2
INFLATION TARGETING USING TAYLOR TYPE OF RULES -------------------------------------------- 2
RATIONALE FOR INFLATION TARGETING IN INDIA ----------------------------------------------------- 3
RATIONALE FOR NOMINAL GDP TARGETING IN INDIA ...view middle of the document...

Inflation is controlled by central bank using monetary policy, fixed exchange rates (usually replaced by floating rates), maintaining a representative money or wage controls.


First proposed by John B. Taylor, the Taylor Rule, also known as Taylor principle; is a monetary policy rule that dictates how much the central banks should change the nominal interest rates in response to the inflation, output (GDP) and other macro-economic factors. According to the rule, the nominal interest rate should respond to the divergences of the actual inflation rate to the targeted inflation rate and of actual Gross Domestic Product (GDP) to the potential Gross Domestic Product (GDP):


In this equation, is the target short-term nominal interest rate, is the rate of inflation as measured by the GDP deflator, is the desired rate of inflation, is the assumed equilibrium real interest rate, is the logarithm of real GDP, and is the logarithm of potential output, as determined by a linear trend.

In the equation, both and are determined by past data that describe the relationship between interest rate and inflation and the interest rate and GDP respectively, and are always positive. Hence, the rule recommends a high interest rate in cases where the inflation is above targeted inflation and/or when the GDP exceeds the potential GDP of the economy to reduce the inflationary pressures. Conversely, it recommends to lower the rates in opposite situation, thereby promoting growth. In situation of stagflation in which, the inflation is above the target while the output is below its potential, the rules specifies that relative weights be given to reducing inflation versus increasing output.
In effect, the rule states that when the inflation or the GDP increases form the target by 1% then the interest rates should increase by more than 1%. The rule acts as a tool to understand the...

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